424B4 1 d424b4.htm FORM 424B4 Form 424B4
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Filed Pursuant to Rule 424(b)(4)
Registration No. 333-169699

5,800,000 American Depositary Shares

LOGO

ShangPharma Corporation

Representing 104,400,000 Ordinary Shares

 

 

This is our initial public offering. We are offering 3,200,000 American depositary shares, or ADSs, and certain of our shareholders identified in this prospectus are offering an additional 2,600,000 ADSs. Each ADS represents 18 of our ordinary shares, par value $0.001 per share. We will not receive any proceeds from the ADSs sold by the selling shareholders. No public market currently exists for our shares or ADSs.

The initial public offering price of our ADSs is $15.00 per ADS. Our ADSs have been approved for listing on the New York Stock Exchange under the symbol “SHP.”

Investing in our ADSs involves a high degree of risk. See “Risk Factors” beginning on page 11.

 

 

 

         Per ADS              Total      

Public offering price

   $ 15.00       $ 87,000,000   

Underwriting discounts and commissions

   $ 1.05       $ 6,090,000   

Proceeds, before expenses, to ShangPharma Corporation

   $ 13.95       $ 44,640,000   

Proceeds, before expenses, to the selling shareholders

   $ 13.95       $ 36,270,000   

The selling shareholders have granted the underwriters a 30-day option to purchase up to 870,000 additional ADSs at the initial public offering price less underwriting discounts and commissions.

Delivery of our ADSs will be made on or about October 22, 2010.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

 

 

 

Citi   J.P. Morgan
William Blair & Company   Oppenheimer & Co.

The date of this prospectus is October 18, 2010.


Table of Contents

 

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Table of Contents

 

TABLE OF CONTENTS

 

     Page  

PROSPECTUS SUMMARY

     1   

SUMMARY CONSOLIDATED FINANCIAL DATA

     9   

RISK FACTORS

     11   

FORWARD-LOOKING STATEMENTS

     35   

USE OF PROCEEDS

     37   

DIVIDEND POLICY

     38   

CAPITALIZATION

     39   

DILUTION

     40   

EXCHANGE RATES

     42   

ENFORCEABILITY OF CIVIL LIABILITIES

     43   

SELECTED CONSOLIDATED FINANCIAL DATA

     45   

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     48   

OUR CORPORATE STRUCTURE

     72   

OUR INDUSTRY

     73   

BUSINESS

     82   

REGULATION

     96   

MANAGEMENT

     105   

PRINCIPAL AND SELLING SHAREHOLDERS

     113   

RELATED PARTY TRANSACTIONS

     115   

DESCRIPTION OF SHARE CAPITAL

     117   

DESCRIPTION OF AMERICAN DEPOSITARY SHARES

     125   

SHARES ELIGIBLE FOR FUTURE SALE

     135   

TAXATION

     137   

UNDERWRITING

     143   

EXPENSES RELATED TO THIS OFFERING

     150   

LEGAL MATTERS

     151   

EXPERTS

     152   

WHERE YOU CAN FIND ADDITIONAL INFORMATION

     153   

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

     F-1   

 

 

You should rely only on the information contained in this prospectus or in any related free writing prospectus that we have filed with the Securities and Exchange Commission, or the SEC. We have not authorized anyone to provide you with information that is different. This prospectus may only be used where it is legal to offer and sell these securities. Unless otherwise indicated, the information in this document may only be accurate as of the date of this document.

We have not taken any action to permit a public offering of the ADSs outside the United States. Persons outside the United States who come into possession of this prospectus must inform themselves about and observe any restrictions relating to the offering of the ADSs and the distribution of the prospectus outside the United States.

Through and including November 12, 2010, all dealers that effect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers’ obligation to deliver a prospectus when acting as an underwriter and with respect to their unsold allotments or subscriptions.


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PROSPECTUS SUMMARY

You should read the following summary together with the entire prospectus, including the more detailed information regarding us, the ADSs being sold in this offering, and our consolidated financial statements and related notes appearing elsewhere in this prospectus. You should consider carefully, among other things, the matters discussed in the section entitled “Risk Factors.” This summary and other sections of this prospectus contain information from a report, referred to in this prospectus as the Frost & Sullivan Report, which we commissioned Frost & Sullivan, an independent market research firm, to provide information on the industry in which we operate, including our market position in that industry.

Our Company

We are a leading China-based pharmaceutical and biotechnology research and development, or R&D, outsourcing company. We provide a broad range of high-quality, integrated services across the drug discovery and development process to international and Chinese pharmaceutical and biotechnology companies. Our services consist of discovery chemistry, discovery biology and preclinical development, pharmaceutical development and biologics services. We offer our services on a full-time-equivalent, or FTE, basis or a fee-for-service basis. Capitalizing on our broad service offerings, the experience and expertise of our skilled scientists and our state-of-the-art facilities and equipment, we help our customers discover and develop novel drug candidates efficiently. We have a diversified and loyal global customer base. We provide services to over 100 customers, including all of the top ten pharmaceutical and biotechnology companies in the world in terms of 2009 revenues ranked by Frost & Sullivan and a number of fast-growing biotechnology and specialty pharmaceutical companies, as well as renowned academic and research institutions in the U.S. and China. Most of our customers return to us for additional and often larger projects, and all of our top ten customers in each of 2008 and 2009 remain our customers in 2010.

Our experienced and strong R&D team contributes significantly to our market leadership. We have successfully grown our scientific research staff from 988 as of December 31, 2007 to 1,525 as of June 30, 2010. Over 60% of our scientific research staff have post-graduate degrees, including many native Chinese scientists and managers who have returned to China after studying or working overseas with experience in global pharmaceutical and biotechnology companies and knowledge of Western business practices. These Western-educated native Chinese who have returned to China are commonly referred to as returnees. Based in China and headquartered in Shanghai, we are well-positioned to attract a large number of returnees and benefit from an abundant supply of highly skilled, domestically-trained scientific talent in China. We attract, retain and motivate our employees through a comprehensive training and career development program and equity incentive plans.

We conduct our laboratory activities in four primary facilities in China: (i) an approximately 450,000 square-foot laboratory and headquarters in Shanghai Zhangjiang Hi-Tech Park; (ii) an approximately 13,000 square-foot AAALAC-accredited animal facility in Shanghai Zhangjiang Hi-Tech Park; (iii) an approximately 36,000 square-foot R&D center in Chengdu; and (iv) an approximately 28,000 square-foot manufacturing facility in Nanhui, Shanghai. In addition, we are constructing an approximately 460,000 square-foot cGMP-quality multi-purpose manufacturing facility in Fengxian, Shanghai, designed to manufacture advanced intermediates and active pharmaceutical ingredients, or APIs, for preclinical testing and clinical trials. We are also constructing an approximately 150,000 square-foot laboratory services building in Fengxian, Shanghai primarily for pharmaceutical development services. Our strategic location in China provides us many advantages, including relatively low-cost labor, developed infrastructure and favorable government incentives as well as a large talent pool.

 

 

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We have experienced significant growth in recent years. Our net revenues increased from $34.7 million in 2007 to $60.5 million in 2008 and $72.3 million in 2009, representing a compound annual growth rate, or CAGR, of 44.4%, and increased by 27.2% from $32.7 million in the six months ended June 30, 2009 to $41.6 million in the six months ended June 30, 2010. The number of our customers increased from 71 in 2007 to 99 in 2008, 134 in 2009 and 151 in the six months ended June 30, 2010. Our net income increased from $7.5 million in 2007 to $9.1 million in 2008 and $9.8 million in 2009, and increased from $4.6 million in the six months ended June 30, 2009 to $6.9 million in the six months ended June 30, 2010.

In 2008, 2009 and the nine months ended September 30, 2010, our founders granted restricted share units, or RSUs, convertible to 7,450,000, 2,100,000 and 2,200,000 ordinary shares, respectively, to certain members of our senior management and other employees under the Founder’s 2008 Equity and Performance Incentive Plan, or the Founder’s Plan. We have not recorded any share-based compensation expense in connection with these RSU grants because one of the vesting conditions for the RSUs is the completion of our initial public offering. As a result, immediately upon completion of this offering, we expect to incur a significant share-based compensation charge of approximately $2.5 million, which will materially and adversely affect our results of operations for the quarter in which this offering is completed.

Our Services

We provide a broad range of high-quality, integrated services across the drug discovery and development process to help international and Chinese pharmaceutical and biotechnology companies discover and develop novel drug candidates efficiently. Our service offerings include the following:

 

   

discovery chemistry, consisting primarily of medicinal chemistry, synthetic chemistry, library generation and analytical chemistry;

 

   

discovery biology and preclinical development, consisting primarily of assay development and high throughput screening, pharmacology, reagent generation, DMPK, ADME profiling, metabolite identification, bioanalytical services and non-GLP toxicology;

 

   

pharmaceutical development, consisting primarily of preformulation and formulation, process R&D, analytical development and research manufacturing; and

 

   

biologics, consisting primarily of therapeutic antibody generation, antibody optimizing and engineering, and analytical services for large molecules.

We believe our customers value our ability to offer a wide range of quality services to meet their drug R&D needs, and we expect to expand our service offerings along the drug discovery and development value chain.

Our Industry

The global contract research organization, or CRO, industry has grown significantly in recent years and is expected to continue to expand, driven primarily by the ability of CROs to contain costs, provide increased flexibility, deliver a broad service platform and reduce time to market.

Outsourcing to emerging countries such as China has increased in recent years. According to Frost & Sullivan, the Chinese CRO market grew at a CAGR of 27.2% from $380 million in 2007 to $615 million in 2009, and is projected to grow at a CAGR of 20.7% to $1.3 billion in 2013. The principal growth drivers include lower-cost and high-quality services, a large talent pool, the increasing breath of R&D service offerings, a large supply of treatment naive patients, a growing domestic pharmaceutical market and strong government support.

 

 

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Our Strengths and Strategies

We believe that the following strengths contribute to our success and differentiate us from our competitors:

 

   

leading market position with proven track record;

 

   

seasoned management and experienced R&D team;

 

   

integrated service platform with comprehensive service offerings;

 

   

loyal and diversified global customer base;

 

   

efficient service provider with competitive cost structure; and

 

   

state-of-the-art facilities with flexible and scalable capacities.

We aim to become one of the world’s leading pharmaceutical and biotechnology R&D outsourcing companies. To achieve this, we intend to pursue the following strategies:

 

   

broaden our service offerings and enhance our service capabilities;

 

   

maintain and expand our customer base;

 

   

attract, train and retain scientific talent;

 

   

enhance our operating efficiency; and

 

   

selectively evaluate and pursue strategic alliance and acquisition opportunities.

Our Challenges

We expect to face risks and uncertainties related to our ability to:

 

   

attract, train, motivate and retain skilled scientists;

 

   

diversify our customer base and adapt to potential loss of sales to, or significant reduction in orders from, any of our major customers;

 

   

adapt our business to industry trends, such as fluctuations in the R&D budgets of pharmaceutical and biotechnology industry participants;

 

   

protect the intellectual property rights of our customers;

 

   

comply with applicable regulations and industry standards;

 

   

compete effectively in our industry, which may subject us to increasing pricing pressure and reduce the demand for our services;

 

   

expand and market our services and manage our growth; and

 

   

develop and maintain effective internal control over financial reporting.

See “Risk Factors” for a detailed discussion of these and other risks that we face.

Corporate History and Structure

We are a Cayman Islands holding company and conduct substantially all of our business through our operating subsidiaries in China. We commenced operations in China in 2002 and established ShangPharma

 

 

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Corporation as an offshore holding company in the Cayman Islands on August 30, 2007. We own 100% of all of our operating subsidiaries in China through two wholly-owned companies incorporated in Hong Kong, China Gateway Life Science (Holdings) Limited and ChemExplorer Company Limited.

The following diagram illustrates our corporate structure and the place of formation of our principal subsidiaries as of the date of this prospectus.

LOGO

Our Corporate Information

Our principal executive offices are located at No. 5 Building, 998 Halei Road, Zhangjiang Hi-Tech Park, Pudong New Area, Shanghai, 201203, People’s Republic of China. Our telephone number at this address is (86-21) 5132-0088. Our registered office in the Cayman Islands is located at Cricket Square, Hutchins Drive, P.O. Box 2681, Grand Cayman, KY1-1111, Cayman Islands. Our agent for service of process in the United States is Law Debenture Corporate Services Inc. located at 400 Madison Avenue, 4th Floor, New York, New York 10017.

Investors should submit any inquiries to the address and telephone number of our principal executive offices. Our main website is www.shangpharma.com. The information contained on our website is not a part of this prospectus.

 

 

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Conventions That Apply to This Prospectus

Unless we indicate otherwise, all information in this prospectus assumes no exercise by the underwriters of their option to purchase up to 870,000 additional ADSs representing 15,660,000 ordinary shares from the selling shareholders.

Except where the context otherwise requires and for purposes of this prospectus only:

 

   

“we,” “us,” “our company,” “our” and “ShangPharma” refer to ShangPharma Corporation, a Cayman Islands company, and its subsidiaries;

 

   

“ADSs” refers to our American depositary shares, each of which represents 18 ordinary shares, and “ADRs” refers to American depositary receipts, which, if issued, evidence our ADSs;

 

   

“China” or the “PRC” refer to the People’s Republic of China excluding, for the purpose of this prospectus only, Hong Kong, Macau and Taiwan;

 

   

“RMB” or “Renminbi” refers to the legal currency of China and “$,” “dollar,” “US$” or “U.S. dollar” refers to the legal currency of the United States; and

 

   

“shares” or “ordinary shares” refers to our ordinary shares, par value $0.001 per share, and “preferred shares” refers to our Series A convertible preferred shares, par value $0.001 per share.

 

 

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The Offering

The following assumes that the underwriters will not exercise their option to purchase additional ADSs in the offering, unless otherwise indicated.

 

ADSs offered by us

3,200,000 ADSs

 

ADSs offered by the selling shareholders

2,600,000 ADSs

 

Offering price

$15.00 per ADS.

 

ADSs outstanding immediately after this offering

5,800,000 ADSs

 

Ordinary shares outstanding immediately after this offering

335,600,000 shares

 

The ADSs

Each ADS represents 18 ordinary shares, par value $0.001 per share.

The depositary will be the holder of the ordinary shares underlying your ADSs and you will have rights as provided in the deposit agreement.

Although we do not expect to pay dividends in the foreseeable future, if we declare dividends on our ordinary shares, the depositary will pay you the cash dividends and other distributions it receives on our ordinary shares, after deducting fees of up to $0.05 per ADS per distribution and expenses.

In addition, the depositary may charge a fee of up to $0.05 per ADS per calendar year (or portion thereof) for services it performs in administering the ADSs (which may be charged on a periodic basis during each calendar year and shall be assessed against holders of ADSs as of the record date or record dates set by the depositary during each calendar year).

 

  You may surrender your ADSs to the depositary along with the ADS cancellation fees of $0.05 per ADS and receive the ordinary shares underlying your ADSs.

We may amend or terminate the deposit agreement without your consent, and if you continue to hold your ADSs, you agree to be bound by the deposit agreement as amended.

You should carefully read the section in this prospectus entitled “Description of American Depositary Shares” to better understand the terms of the ADSs. You should also read the deposit agreement,

 

 

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which is an exhibit to the registration statement that includes this prospectus.

 

Listing

Our ADSs have been approved for listing on the New York Stock Exchange under the symbol “SHP.” Our ADSs and shares will not be listed on any other exchange or quoted for trading on any other automated quotation system.

 

Option to purchase additional ADSs

The selling shareholders have granted to the underwriters an option, exercisable within 30 days from the date of this prospectus, to purchase up to an aggregate of 870,000 additional ADSs.

 

Use of proceeds

Our net proceeds from this offering are expected to be approximately $41.0 million, after deducting underwriting discounts and commissions and the estimated offering expenses payable by us. We will not receive any proceeds from the ADSs sold by the selling shareholders. We anticipate using the net proceeds as follows:

 

    approximately  $15.0 million for the construction of our manufacturing facility and laboratory services building in Fengxian, Shanghai;

 

    approximately $15.0 million for the purchase of equipment;

 

    approximately  $5.0 million for the expansion of our service offerings;

 

    approximately $5.0 million for working capital needs; and

 

    the balance for other general corporate purposes, including potential acquisitions (although we are not currently negotiating any such acquisitions).

 

Depositary

JPMorgan Chase Bank, N.A.

 

Risk factors

See “Risk Factors” and other information included in this prospectus for a discussion of risks you should carefully consider before investing in the ADSs.

 

Lock-up

We, all of our directors, executive officers and existing shareholders, and certain holders of options and RSUs, have agreed with the underwriters not to sell, transfer or otherwise dispose of any of our ordinary shares or ADSs representing our ordinary shares for 180 days after the date of this prospectus. See “Underwriting.”

The number of ordinary shares that will be outstanding immediately after this offering:

 

   

assumes the conversion of all outstanding preferred shares into 69,994,014 ordinary shares immediately prior to the completion of this offering;

 

 

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excludes 36,046,200 ordinary shares issuable upon the exercise of options outstanding as of September 30, 2010 under our 2008 equity and performance incentive plan, as amended and restated on February 24, 2010, or the Plan, at a weighted average exercise price of approximately $0.55 per share; and

 

   

excludes 516,158 ordinary shares reserved for future issuance under the Plan.

 

 

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SUMMARY CONSOLIDATED FINANCIAL DATA

The following summary consolidated statements of operations data for the years ended December 31, 2007, 2008 and 2009 and the summary consolidated balance sheet data as of December 31, 2008 and 2009 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. The following summary consolidated statement of operations data for the six months ended June 30, 2009 and 2010 and the summary consolidated balance sheet data as of June 30, 2010 have been derived from our unaudited condensed consolidated financial statements included elsewhere in this prospectus and have been prepared on the same basis as our audited consolidated financial statements. Our historical results do not necessarily indicate our expected results for any future periods. You should read this Summary Consolidated Financial Data together with our consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus. Our consolidated financial statements are prepared and presented in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP.

 

     Year Ended December 31,     Six Months Ended
June 30,
 
     2007     2008     2009     2009     2010  
     (in millions of $, except for share, per share and per ADS data)  

Consolidated Statements of Operations Data:

          

Net revenues

     34.7        60.5        72.3        32.7        41.6   

Cost of revenues

     (22.8     (40.5     (48.4     (21.8     (27.2
                                        

Gross profit

     11.9        20.0        23.9        10.9        14.4   
                                        

Operating expenses:

          

Selling and marketing

     (0.5     (0.8     (1.7     (0.7     (1.1

General and administrative

     (4.0     (9.3     (12.0     (5.6     (6.9
                                        

Total operating expenses

     (4.5     (10.1     (13.7     (6.3     (8.0
                                        

Profit from operations

     7.4        9.9        10.2        4.6        6.4   

Interest income

     0.2        0.2        *        *        *   

Interest expense

                                 *   

Other income

     0.2        0.9        1.3        0.8        1.6   

Other expenses

     (0.1     (1.6     (0.2     (0.1     (0.2
                                        

Income from operations before income taxes

     7.7        9.4        11.4        5.3        7.8   

Income taxes

     (0.2     (0.3     (1.6     (0.7     (0.9
                                        

Net income attributable to ShangPharma Corporation

     7.5        9.1        9.8        4.6        6.9   

Allocation to preferred shareholders

     (0.7     (2.3     (2.5     (1.2     (1.8
                                        

Net income attributable to ShangPharma Corporation’s ordinary shareholders

     6.8        6.8        7.3        3.4        5.1   
                                        

Net income attributable to ShangPharma Corporation’s ordinary shareholders per share

          

Basic

     0.03        0.03        0.04        0.02        0.02   
                                        

Diluted

     0.03        0.03        0.04        0.02        0.02   
                                        

Net income attributable to ShangPharma Corporation’s ordinary shareholders per ADS(1)

          

Basic

     0.59        0.59        0.63        0.30        0.44   
                                        

Diluted

     0.59        0.59        0.63        0.30        0.44   
                                        

Weighted average ordinary shares outstanding(2)

          

Basic

     208,005,986        208,005,986        208,005,986        208,005,986        208,005,986   
                                        

Diluted

     230,381,122        278,000,000        278,051,299        278,000,000        210,362,840   
                                        

Pro forma earnings per share attributable to ShangPharma Corporation’s ordinary shareholders (unaudited)(3)

          

Basic

         0.04          0.02   
                      

Diluted

         0.04          0.02   
                      

Pro forma weighted average ordinary shares outstanding (unaudited)(2) (3) (4)

          

Basic

         278,000,000          278,000,000   
                      

Diluted

         278,051,299          280,356,854   
                      

 

 

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* Less than $50,000.
(1) Each ADS represents 18 ordinary shares.
(2) In May 2008, we effected a bonus share issuance in the form a share split by issuing an additional approximately 20,800 ordinary shares for each ordinary share outstanding and an additional approximately 20,800 preferred shares for each preferred share outstanding. As a result of the bonus share issuance, the number of outstanding ordinary shares and preferred shares increased to 208,005,986 and 69,994,014, respectively. See “Related Party Transactions—Share Issuances and Splits.” The effect of the bonus share issuance is retroactively reflected for all periods presented herein.
(3) For a description of the pro forma adjustments used to calculate pro forma earnings per share for the year ended December 31, 2009, see “Note 19—Unaudited Pro Forma Balance Sheet and Earnings Per Share for Conversion of Preferred Shares” to our consolidated financial statements included elsewhere in this prospectus.
(4) For a description of the pro forma adjustments used to calculate pro forma earnings per share for the six months ended June 30, 2010, see “Note 15—Unaudited Pro Forma Balance Sheet and Earnings Per Share for Conversion of Preferred Shares” to our unaudited condensed consolidated financial statements included elsewhere in this prospectus.

 

     As of December 31,      As of June 30,  
     2008      2009      2010      2010  
    

(in millions of $)

 
                   (Pro forma)(1)  

Consolidated Balance Sheet Data:

           

Cash

     15.8         12.2         10.0         10.0   

Total current assets

     28.7         30.1         31.9         31.9   

Total assets

     61.7         70.0         78.8         78.8   

Total current liabilities

     17.3         15.5         16.9         16.9   

Total liabilities

     17.3         15.5         16.9         16.9   

Series A convertible preferred shares

     34.4         34.4         34.4         —     

Total equity

     10.0         20.1         27.5         61.9   

 

(1) Pro forma basis reflects the conversion of all outstanding preferred shares on a 1-for-1 basis into an aggregate of 69,994,014 ordinary shares upon the completion of this offering.

 

 

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RISK FACTORS

You should carefully consider the risks described below and all other information contained in this prospectus before making an investment decision. If any of the following risks actually occurs, our business, financial condition and results of operations could be materially and adversely affected. In that event, the trading price of our ADSs could decline, and you may lose part or all of your investment.

Risks Related to Our Business and Industry

Our ability to execute projects, maintain, expand or renew existing customer engagements and obtain new customers depends largely on our ability to attract, train, motivate and retain skilled scientists.

Our success largely depends on the R&D efforts of our skilled scientists and their ability to keep pace with changes in pharmaceutical and biotechnology R&D technologies and methodologies. In particular, our customers value highly skilled Western-trained scientists, preferably with large pharmaceutical and/or biotechnology company experience. Our success also depends on the depth and quantity of our scientific personnel. We face challenges in attracting new employees and maintaining consistent quality standards throughout our employee base at our current growth rate. Our employee base increased from 1,115 as of December 2007 to 1,755 as of June 30, 2010, and is expected to increase in the second half of 2010.

We compete with pharmaceutical, biotechnology and contract research firms and academic and research institutions for qualified and experienced scientists, particularly in chemistry and biology. To effectively compete, we may be required to offer higher compensation and other benefits that could materially and adversely affect our financial condition and results of operations. We may be unable to hire and retain enough skilled and experienced scientists to replace those who leave our company. Additionally, we may be unable to redeploy and retrain our professionals to keep pace with technological changes, evolving standards and changing customer preferences. Any inability to attract, train, motivate or retain skilled scientists may materially and adversely affect our business, financial condition, results of operations and prospects.

A limited number of our customers have accounted for and are expected to account for a high percentage of our revenues. The loss or significant reduction in orders from any of these customers could materially and adversely affect our business, financial condition, results of operations and prospects.

Our two largest customers in 2009 and the six months ended June 30, 2010, Eli Lilly and Company, or Lilly, and GlaxoSmithKline plc, or GSK, respectively accounted for 27% and 10% of our net revenues in 2009 and 20% and 9% of our net revenues in the six months ended June 30, 2010. No other customer accounted for more than 10% of our net revenues in 2009 and the six months ended June 30, 2010. Our top ten customers, which varied in each of the last three years and the six months ended June 30, 2010, accounted for approximately 85%, 77%, 65% and 63% of our net revenues in 2007, 2008, 2009 and the six months ended June 30, 2010, respectively. Furthermore, we generated a significant majority of our net revenues during the same periods from sales to customers located in the United States.

Due to our customer concentration, any of the following events, among others, may cause material revenue fluctuations or declines and materially and adversely affect our business, financial condition, results of operations and prospects:

 

   

order or contract reduction, delay or cancellation by one or more of our significant customers and our failure to identify and acquire additional or replacement customers; and

 

   

a substantial reduction by one or more of our significant customers in the price they are willing to pay for our services and products.

Any failure to retain our existing customers or expand our customer base may result in our inability to maintain or increase our revenues.

Our existing customers may not continue to generate significant revenues for us once our engagements with them are concluded and our relationships with them may not present further business opportunities.

 

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We have entered into master services agreements with some customers, the terms of which typically range from one to five years. If we fail to build new customer relationships or our relationships with existing customers terminate, we may not be able to maintain or increase our revenues.

A reduction in R&D budgets by pharmaceutical and biotechnology companies may result in a reduction or discontinued use of our services, which may adversely affect our business.

Fluctuations in the R&D budgets of pharmaceutical and biotechnology industry participants could significantly affect the demand for our services. R&D budgets fluctuate due to, among other things, pharmaceutical and biotechnology industry downturns, consolidation of pharmaceutical and biotechnology companies, general economic conditions, and changes in available resources, spending priorities and institutional budgetary policies. The global pharmaceutical and biotechnology industry has experienced significant consolidation and, during the global financial crisis, some pharmaceutical and biotechnology companies experienced financial difficulties. We have experienced reductions, delays or cancellations of orders or contracts from certain customers and difficulties in collecting fees from certain customers who experienced financial difficulties or consolidation in the global financial crisis. For example, two of our North America-based biotechnology customers experienced financial difficulties during the global financial crisis and terminated their contracts with us in late 2008. We collected all of the accounts receivable from one of the two customers and part of the accounts receivable from the other one. The amount of uncollected accounts receivable was immaterial and fully reserved for. If pharmaceutical and biotechnology companies discontinue or decrease the use of our services due to factors such as a prolonged slowdown in the overall U.S. or global economy or further industry consolidation, our revenues and earnings could be lower than we expect and our revenues may decrease or fail to grow at historical rates.

The outsourcing trend in the drug R&D industry may decrease, which could slow our growth.

The success of our business depends primarily on the number of contracts and the size of the contracts that we obtain from pharmaceutical and biotechnology companies. Over the past several years, our business has benefited from increased levels of outsourcing of drug R&D by pharmaceutical and biotechnology companies. While the outsourcing trend is expected to continue for the next several years, a reversal or slowing of this trend could result in diminished growth in our expected growth areas and materially adversely affect our business, financial condition, results of operations and prospects.

If we fail to protect the intellectual property rights of our customers, we may be subject to liability for breach of contract and may suffer damage to our reputation.

Protection of intellectual property associated with pharmaceutical and biotechnology R&D services is critical to all our customers. Our customers generally retain ownership of associated intellectual property rights, including those they provide to us and those arising from the services we provide. Our success therefore depends in substantial part on our ability to protect the proprietary rights of our customers. This is particularly important for us because almost all of our operations are based in China, which has not traditionally enforced intellectual property protection to the same extent as in the United States. Despite measures we take to protect our customers’ and our own intellectual property, unauthorized parties may attempt to obtain and use information that we regard as proprietary. Any unauthorized disclosure of our customers’ proprietary information could subject us to liability for breach of contract and significantly damage our reputation, which could materially harm our business, financial condition, results of operations and prospects.

Any failure to comply with applicable regulations and industry standards or obtain various licenses and permits could harm our reputation and our business, results of operations and prospects.

A number of governmental agencies or industry regulatory bodies in China, the United States and Europe, impose strict rules, regulations and industry standards governing pharmaceutical and biotechnology R&D activities, which apply to our customers and us. Our failure to comply with such regulations could result in the termination of ongoing research, administrative penalties imposed by regulatory bodies or the disqualification of data for submission to regulatory authorities. This could harm our reputation, prospects for future work and

 

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operating results. For example, if we were to treat research animals inhumanely or in violation of international standards set out by the Association for Assessment and Accreditation of Laboratory Animal Care, or AAALAC, AAALAC could revoke any such accreditation and the accuracy of our animal research data could be questioned.

In addition, our subsidiaries in China need to obtain various licenses and permits to conduct their current operations. If any of our subsidiaries in China is unable to obtain all the requisite licenses and permits or fails to renew any of the licenses or permits timely, it may be subject to fines and other penalties, including suspension of its operations.

Compliance with environmental regulations can be expensive, and noncompliance with these regulations may result in significant monetary damages, fines and other penalties.

As our pharmaceutical and biotechnology R&D processes generate waste water, toxic and hazardous substances and other industrial wastes, we must comply with all national and local environmental laws and regulations in China. We are required to undertake environmental impact assessment procedures and pass the subsequent inspection and approval procedures before commencing our operations. We are also required to register with, or obtain approvals from, relevant environmental protection authorities for various environmental matters such as discharging waste generated in our operations. We did not complete certain environmental assessment or approval procedures for some of our facilities. We are taking remedial measures necessary to obtain the requisite approvals. We have engaged a qualified assessment consultant to conduct environmental impact assessments. We had submitted the application for approval of the environmental impact assessment report for our principal facilities in Shanghai by the end of August 2010. According to relevant PRC regulations, the local environmental protection authorities are required to complete the inspection and approval procedures within several months upon receipt of an application for approval of the environmental impact assessment. However, we cannot assure you that the remedial measures we are taking will be completed timely and successfully. If for any reason the relevant government authorities in China determine that we are not in compliance with environmental laws and regulations, we may be required to pay fines or damages to third parties or suspend our operations. In addition, because the requirements imposed by environmental laws and regulations may change and more stringent regulations may be adopted, we may be unable to accurately predict the cost of complying with these laws and regulations, which could be substantial.

We are subject to safety and health laws and regulations in China, and any failure to comply could adversely affect our operations.

Our operations and facilities are subject to extensive safety and health laws and regulations. We must ensure that our operations and facilities comply with PRC standards and requirements on fire prevention, hazardous and radioactive materials handling, work environment safety and employees’ health conditions. We have not completed certain procedures for some of our facilities or projects required for compliance with these laws and regulations, such as having our relevant work environments inspected for occupational hazards. We are taking remedial measures to rectify such non-compliance. For example, we have had our material work areas inspected for occupational hazards. However, we may be subject to government orders to rectify non-compliance within a specified period, pay fines or suspend our operations. In addition, we cannot eliminate the risk of accidental contamination or injury from hazardous or radioactive materials used in our operations. If we fail to prevent contamination or injury, we could be liable for any resulting damages, which may materially and adversely impact our business, financial condition, results of operations and prospects.

Any failure by us to satisfy our customers’ audits and inspections could harm our reputation and our business, financial condition, results of operations and prospects.

Our customers routinely audit and inspect our facilities, processes and practices to ensure that we meet their standards for drug discovery and development. To date, we are not aware of any material negative findings from our customers’ audits and inspections. However, we may not be able to pass all such audits and inspections to our customers’ satisfaction, and any such failure may significantly harm our reputation and materially and adversely affect our business, financial condition, results of operations and prospects.

 

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We face increasingly intense competition. If we do not compete successfully against new and existing competitors, demand for our services and related revenues may decrease and we may be subject to increasing pricing pressure.

The global pharmaceutical and biotechnology R&D outsourcing market is highly competitive, and we expect competition to intensify. We face competition based on several factors, including the quality and scope of services, the ability to protect confidential information and intellectual property, the ability to be responsive and efficient with respect to customers’ requests, depth of customer relationship and pricing. We compete with WuXi PharmaTech (Cayman) Inc., or WuXi PharmaTech, across the breadth of our service offerings. We also compete with industry participants in particular service areas, including Albany Molecular Research, Inc. in discovery chemistry and pharmaceutical development, and Cerep S.A. and Covance Inc. in discovery biology and preclinical development.

We expect to increasingly compete against multinational companies, both domestically and internationally, as we offer more complex and sophisticated services. Additionally, several major pharmaceutical and biotechnology companies have made in-house R&D investments in China, a trend we expect to continue. These in-house investments may result in increased competition for qualified personnel. Some of our larger competitors may have greater financial, research and other resources, broader scope of services, greater pricing flexibility, more extensive technical capabilities and greater name recognition than we do. Furthermore, consolidation within the global pharmaceutical and biotechnology R&D outsourcing markets may create stronger competitors than those we are facing today.

We also expect increased competition as new companies enter into our market and more advanced technologies become available. Our services and expertise may be rendered obsolete or uneconomical by technological advances or new approaches or technologies. Our competitors’ existing or new approaches or technologies they develop may be more effective than those we develop. Furthermore, increased competition may subject us to increasing pricing pressure and reduce demand for our services, which could reduce our margins and profitability.

We may fail to effectively expand and market our service offerings and capabilities, which may harm our growth opportunities and prospects, possibly resulting in related losses.

We intend to expand our existing services and offer new services across the drug discovery value chain. Initially focusing on discovery chemistry services, we introduced pharmaceutical development services in 2005 and discovery biology and preclinical development services in 2007. We began offering biologics services in early 2010. We are constructing an approximately 460,000 square-foot cGMP-quality multi-purpose manufacturing facility in Fengxian, Shanghai designed to manufacture advanced intermediates and APIs for preclinical testing and clinical trials. We are also constructing an approximately 150,000 square-foot laboratory services building in Fengxian, Shanghai primarily for pharmaceutical development services. To successfully develop and market our new services, we must:

 

   

accurately assess and meet customer needs and market demands;

 

   

optimize our drug discovery and development processes to predict and control costs;

 

   

hire, train and retain scientists and other personnel;

 

   

provide services in a timely manner;

 

   

increase customer awareness and acceptance of our services;

 

   

obtain required regulatory clearances or approvals;

 

   

compete effectively with other R&D outsourcing providers;

 

   

price our services competitively; and

 

   

effectively integrate customer feedback into our business planning.

 

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If we are unable to expand our service offerings and create demand for those newly expanded services, our business, results of operations, financial condition and prospects may be materially and adversely affected.

We may be unable to expand our capacity and scale up our operations as anticipated, possibly resulting in material delay, increased costs and lost business opportunities.

We are developing an approximately 460,000 square-foot cGMP-quality multi-purpose manufacturing facility in Fengxian, Shanghai designed to manufacture advanced intermediates and APIs for preclinical testing and clinical trials. We are also constructing an approximately 150,000 square-foot laboratory services building in Fengxian, Shanghai primarily for pharmaceutical development services. We may not construct such facility or building in accordance with the anticipated timetable or within budget. We may lease or build additional animal facilities in Shanghai if the demand for our discovery biology and preclinical development services increases. In addition, we may lease additional lab and office facilities in Chengdu if the demand for our discovery chemistry services increases. Any material delay in bringing these facilities online or scaling up operations, or any substantial cost increases to complete them or scale up operations, could materially and adversely affect our financial condition and results of operations, and result in lost business opportunities.

If we fail to effectively manage our anticipated growth and execute our growth strategies, our business, financial condition, results of operations and prospects could suffer.

Pursuing our growth strategies, including integrating and expanding our facilities and service offerings to meet our customers’ needs, has resulted in and will continue to place substantial demands on our management and resources. Managing this growth and executing our growth strategies will require, among other things:

 

   

enhancement of our pharmaceutical and biotechnology R&D capabilities;

 

   

effective coordination and integration of our research facilities and teams, particularly those located in different or newly opened facilities;

 

   

successful personnel hiring and training;

 

   

effective cost controls and sufficient liquidity;

 

   

effective and efficient financial and management controls;

 

   

increased marketing and sales support activities;

 

   

effective quality control; and

 

   

our ability to manage our various vendors and suppliers and leverage our purchasing power.

Any failure to effectively manage our anticipated growth and execute our growth strategies could materially adversely affect our business, financial condition, results of operations and prospects.

If our company or our founders grant employees share options and other share-based compensation in the future, our net income may be adversely affected. In addition, we will incur non-cash share-based compensation charges in connection with the RSUs granted under the Founder’s Plan upon completion of this offering, which will materially and adversely impact our results of operations.

Our equity incentive plans and other similar types of incentive plans are important in order to attract and retain key personnel. Our company and our founders have granted our employees share options and restricted share units in the past pursuant to the Plan and the Founder’s Plan. As a result of the issuance of options and RSUs under these plans, we have in the past and expect in the future to incur share-based compensation expenses. We account for compensation costs for all share options, including share options granted to our employees, non-employee directors and officers using the fair value determined at the grant date and recognize the expense in our consolidated statement of operations. We also account for compensation costs for the conversion of RSUs into our ordinary shares. These compensation costs may materially and adversely affect our net income. Moreover, the additional expenses associated with share-based compensation may reduce the attractiveness of our equity incentive plans.

 

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In 2008, 2009 and the nine months ended September 30, 2010, our founders granted RSUs convertible to 7,450,000, 2,100,000 and 2,200,000 ordinary shares, respectively, to certain members of our senior management and other employees under the Founder’s Plan. We have not recorded any share-based compensation expense in connection with these RSU grants because one of the vesting conditions for the RSUs is the completion of our initial public offering. As a result, immediately upon completion of this offering, we will incur a significant share-based compensation charge of approximately $2.5 million, which will materially and adversely affect our results of operations for the quarter in which this offering is completed.

In providing our pharmaceutical and biotechnology R&D outsourcing services, we face health and safety liability and product liability risks.

In providing our services in connection with drug discovery and development, we face a range of potential liabilities, which include risks that disease models and animals infected with diseases for research interests may be harmful, or even lethal, to themselves and humans despite preventive measures we take for the quarantine and handling of animals. We also face product liability risks should the drugs we assist in developing and manufacturing become subject to product liability claims. We provide services in the development, testing and manufacturing of drugs that may ultimately be used by humans, although we do not commercially market or sell the products to end users. If any of these drugs harm people, we may be subject to litigation and may be required to pay damages to those persons.

We do not have general liability or product liability insurance covering our whole business or all of our products and services. We currently maintain general liability insurance for four contracts covering, among other things, bodily injury and property damage arising out of the products or services provided under these contracts. The aggregate net revenues derived from these contracts in the six months ended June 30, 2010 accounted for 11.0% of our total net revenues in this period. The aggregate maximum coverage amount under the insurance policy for these contracts is $5 million for bodily injury and property damage arising out of our products or services and economic loss sustained by persons or entities due to deficiencies in our products or services. Damages awarded in a product liability action could be substantial and, to the extent not covered by our insurance, could materially and adversely impact our business, financial condition and results of operations.

Because many of our fee-for-service based contracts are contingent on successful completion and are of a fixed price nature, we may bear risk if we do not successfully or timely develop a service or enter contracts with pricing below our estimated cost due to competitive pressures or strategic objectives, or incur overrun costs.

A significant portion of our net revenues is based on fee-for-service contracts, which are contingent on successful completion and are often for a fixed price. Therefore, we bear financial risk if we do not successfully or timely complete services or if we price our fee-for-service based contracts below our estimated cost of completing these contracts or otherwise incur cost overruns. We also face pricing pressures from some of our competitors. To capture market share, we have, in the past, intentionally priced some fee-for-service based contracts below our estimated cost of completing these contracts. Below-cost pricing or significant cost overruns could materially and adversely affect our business, financial condition, results of operations and prospects.

The loss of services of our senior management and key scientific personnel could severely disrupt our business and growth.

Our success significantly depends upon the continued service of our senior management and key scientific personnel. We are highly dependent on Mr. Michael Xin Hui, our co-founder and chief executive officer, who has managed our business, operations and sales and marketing activities and maintained personal and direct relationships with our major customers since our inception, as well as other members of our management and other key scientific personnel. The loss of any one of them, in particular Mr. Hui, would materially and adversely affect our business. Although each member of our senior management and key scientific personnel has signed a noncompete agreement with us, we may be unable to successfully enforce these provisions in the event of a dispute. If we lose the services of any of our senior management members or key scientific personnel, we may be unable to locate suitable or qualified replacements, and may incur additional expenses to recruit and train new personnel, which could severely disrupt our business and growth.

 

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A payment failure by any of our large customers could adversely affect our cash flows and profitability.

Historically, we have not experienced any significant bad debt or collection problems, but such problems may arise in the future. The failure of any of our customers to make timely payments could require us to write off accounts receivable or increase provisions made against our accounts receivable, either of which could adversely affect our cash flows and profitability.

Our limited operating history may make it difficult for you to evaluate our business and future prospects.

We commenced operations and began offering our pharmaceutical and biotechnology R&D outsourcing services in 2002. Our business model changes with the evolution of the pharmaceutical and biotechnology R&D outsourcing market in China and around the world. Accordingly, our operating history upon which you can evaluate the viability and sustainability of our business and its acceptance by industry participants is limited. These circumstances may make it difficult for you to evaluate our business and future prospects, and you should not rely on our past results or our historic growth rate as an indication of our future performance.

In preparing our consolidated financial statements, we have identified one material weakness and other deficiencies in our internal control over financial reporting. If we fail to develop and maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud, and investor confidence in our company and the market price of our ADSs may be adversely affected.

Prior to this offering, we have been a private company with limited accounting personnel and other resources with which to address our internal control over financial reporting. In preparing our consolidated financial statements, we and our independent registered public accounting firm identified one material weakness and other deficiencies in our internal control over financial reporting as of December 31, 2009. As defined in the standards established by the U.S. Public Company Accounting Oversight Board, or the PCAOB, a “material weakness” is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.

The material weakness identified related to a lack of sufficient competent personnel with appropriate levels of accounting knowledge and experience to perform period end reporting procedures, address complex U.S. GAAP accounting issues and prepare and review financial statements and related disclosures under U.S. GAAP. Neither we nor our independent registered public accounting firm undertook a comprehensive assessment of our internal control for purposes of identifying and reporting material weaknesses and other control deficiencies in our internal control over financial reporting as we and they will be required to do once we become a public company. Had we performed a formal assessment of our internal control over financial reporting or had our independent registered public accounting firm performed an audit of our internal control over financial reporting, additional deficiencies may have been identified.

Following the identification of the material weakness and other control deficiencies, we have taken measures and plan to continue to take measures to remedy these control deficiencies. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Internal Control over Financial Reporting.” However, the implementation of these measures may not fully address these deficiencies in our internal control over financial reporting, and we cannot conclude that they have been fully remedied. Our failure to correct these control deficiencies or our failure to discover and address any other control deficiencies could result in inaccuracies in our financial statements and impair our ability to comply with applicable financial reporting requirements and related regulatory filings on a timely basis. As a result, our business, financial condition, results of operations and prospects, as well as the trading price of our ADSs, could be materially and adversely affected. Moreover, ineffective internal control over financial reporting significantly hinders our ability to prevent fraud.

 

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Upon completion of this offering, we will become subject to the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act. Section 404 of the Sarbanes-Oxley Act requires that we include a report from management on the effectiveness of our internal control over financial reporting in our annual report on Form 20-F beginning with our annual report for the fiscal year ending December 31, 2011. In addition, beginning at the same time, our independent registered public accounting firm must report on the effectiveness of our internal control over financial reporting. If we fail to remedy the problems identified above, our management and our independent registered public accounting firm may conclude that our internal control over financial reporting is not effective. This could adversely impact the market price of our ADSs due to a loss of investor confidence in the reliability of our reporting processes. We will need to incur significant costs and use significant management and other resources in order to comply with Section 404 of the Sarbanes-Oxley Act.

Our business is sensitive to the current global economic crisis. A severe or prolonged downturn in the global or Chinese economy could materially and adversely affect our business, results of operations and financial condition.

The global financial markets have experienced significant disruptions since 2008, and most of the world’s major economies are in or are just emerging from recession. While there has been improvement in some areas, it is still unclear whether the recovery is sustainable. There is considerable uncertainty over the long-term effects of the expansionary monetary and fiscal policies adopted by the central banks and financial authorities of the world’s leading economies, including those of the United States and China. Continued concerns about the systemic impact of potential long-term and wide-spread recession, energy costs, geopolitical tensions, the availability and cost of credit, and the global housing and mortgage markets have contributed to increased market volatility and diminished expectations for economic growth around the world. Any prolonged slowdown in the global or Chinese economy or downturn in the pharmaceutical and biotechnology industry may negatively impact our business, results of operations and financial condition, and continued turbulence in the international markets may adversely affect our ability to access the capital markets to meet liquidity needs.

Our customer agreements contain provisions that are adverse to our interests or expose us to potential liability.

Our agreements with our customers generally provide that customers can terminate the agreements or reduce the scope of services under the agreements upon short notice. In a majority of our customer agreements, our customers have the unilateral right to terminate for convenience upon one to three months’ prior notice. Although we have not been materially and adversely affected by previous contract cancellations or modifications, if a customer terminates a contract with us, we are only entitled under the terms of the contract to receive revenue earned until the date of termination. Therefore, cancellation or modification of a large contract or cancellation or modification of multiple contracts could materially and adversely affect our business, financial condition, results of operations and prospects.

In certain of our customer agreements, we have assumed indemnification obligations for intellectual property infringement resulting from the misuse of confidential information by our employees or from the customer deliverables that we provide to the extent that we create the infringing aspect of the deliverables. As a result, we could be potentially exposed to substantial liability.

In addition, in some of our customer agreements, we agree, either by ourselves or together with third parties, not to compete with the customer. In some cases, we are required to seek the customer’s prior written consent before working for other customers on similar projects. Complying with these noncompete obligations may restrict our ability to expand certain service offerings, and failure to comply could significantly harm our business and reputation, as well as expose us to liability for breach of contract.

 

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We use a limited number of suppliers, including a related party, Labpartner (Shanghai) Co., Ltd., for several of our service offerings, which, if interrupted, could disrupt or delay our services, reduce our sales and force us to use more expensive supply sources.

We use a limited number of sources for our supply of certain reagents and other chemicals required in our product and service offerings. In particular, we purchased significant amounts of reagents and other chemicals from Labpartner (Shanghai) Co., Ltd., or Labpartner, a related party, in each of 2007, 2008 and 2009. Disruptions or delays with respect to our suppliers may arise from health problems, export or import restrictions or embargoes, foreign government or economic instability, severe weather conditions, disruptions to the air travel system, contract disputes or other disruptions. If the supply of certain materials were interrupted, our services may be delayed. We also may not be able to secure alternative supply sources in a timely and cost-effective manner. If we are unable to obtain adequate supplies of required materials that meet our standards or at acceptable costs, or at all, our ability to accept and fulfill customer orders in the required quality and quantity and at the required time could be restricted, which in turn may materially and adversely affect our business, financial condition, results of operations and prospects.

We have limited insurance coverage, and any claims beyond our insurance coverage may result in our incurring substantial costs and a diversion of resources.

We maintain property insurance policies covering physical damage or loss of our equipment and office furniture, employer’s liability insurance generally covering death or work injury of employees, public liability insurance covering third party bodily injury and property damage incurred in connection with our business in China, and directors and officers liability insurance. We do not have general liability or product liability insurance covering our whole business or all of our products and services. We currently maintain general liability insurance for four contracts covering, among other things, bodily injury and property damage arising out of the products or services provided under these contracts. The aggregate net revenues derived from these contracts in the six months ended June 30, 2010 accounted for 11.0% of our total net revenues in this period. The aggregate maximum coverage amount under the insurance policy for these contracts is $5 million for bodily injury and property damage arising out of our products or services and economic loss sustained by persons or entities due to deficiencies in our products or services. We do not maintain business disruption insurance or key man life insurance. Any business disruption or litigation, or any liability or damage to, or caused by, our facilities or our personnel beyond our insurance coverage may result in substantial costs and a diversion of resources.

Our quarterly revenues and operating results may be difficult to predict and could fall below investor expectations, which could cause the market price of our ADSs to decline.

Our quarterly revenues and operating results have fluctuated in the past and may continue to fluctuate significantly due to numerous factors, including:

 

   

the commencement, postponement, completion or cancellation of large contracts;

 

   

the progress of ongoing contracts;

 

   

the delivery schedule of our customers;

 

   

budget cycles of our customers;

 

   

changes in the mix of our revenues from our services based on a fee-for-service or FTE basis or the percentage of our fee-for-service based contracts that are contingent upon successful completion;

 

   

changes in the industry operating environment;

 

   

changes in government policies or regulations or their enforcement;

 

   

exchange rate fluctuations;

 

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a downturn in general economic conditions in the United States, China or internationally; and

 

   

the timing of and charges associated with completed acquisitions or other events.

Many of these factors are beyond our control, making our quarterly results fluctuate and difficult to predict. For example, revenues may not be recognized during the third quarter of 2010 due to changes in delivery schedules initiated by customers or delays in customer acceptance of deliverables. As a result, our revenues in the third quarter of 2010 may not grow as quickly as they have in previous quarterly periods. Fluctuations in our quarterly revenues and operating results could cause the trading price of our ADSs to decline below investor expectations.

We may need additional capital that we may be unable to obtain in a timely manner or on acceptable terms, or at all.

We may require additional capital in order to grow, remain competitive, develop new services and expand our capacity. Our ability to obtain capital is subject to a variety of uncertainties, including:

 

   

our financial condition, results of operations and cash flows;

 

   

general market conditions for capital raising activities by healthcare and related companies; and

 

   

economic, political and other conditions in China, the United States and elsewhere.

However, financing may not be available in amounts or on terms acceptable to us, if at all.

Our capital needs may require us to sell additional equity or debt securities that may dilute our shareholders or introduce covenants that may restrict our operations or our ability to pay dividends.

Our capital needs and other business reasons could require us to sell additional equity or debt securities or obtain additional credit facilities. The sale of additional equity or equity-linked securities could dilute our shareholders. The incurrence of indebtedness would increase our debt service obligations and could result in operating and financing covenants that would restrict our operations or our ability to pay dividends.

Acquisitions or investments could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our business.

We anticipate that a portion of any future growth of our business might be accomplished by acquiring businesses, products or technologies. The success of any acquisition will depend upon, among other things, our ability to integrate acquired personnel, operations, products and technologies into our organization effectively, to retain and motivate key personnel of the acquired businesses and to retain their clients. In addition, we might not be able to identify suitable acquisition opportunities or obtain any necessary financing on acceptable terms. We might also spend time and money investigating and negotiating with potential acquisition or investment targets, but not complete a transaction. Any acquisition could involve other risks, including the assumption of additional liabilities and expenses, issuances of potentially dilutive securities or interest-bearing debt, transaction costs, reduction in our ADS price as a result of any of these or because of market reaction to a transaction and diversion of management’s attention from other concerns.

Recent healthcare reform creates uncertainty in the need for our services.

In March 2010, the United States Congress passed the Patient Protection and Affordable Care Act. Implementation of this newly enacted act, which is intended to control health care costs, may limit profits from the development of new drugs. Similar reform movements have occurred or may occur in parts of Europe and Asia. It is unclear how these reforms may affect R&D expenditures by pharmaceutical and biotechnology

 

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companies, which creates uncertainty in the business opportunities available to us in the United States and other countries.

Negative attention from special interest groups may impair our ability to operate our business efficiently.

Some of the services we provide, or intend to provide, involve the use of large and small animals, as well as non-human primates. Certain special interest groups categorically object to the use of animals for research purposes. Historically, our core research model activities with small animals have not been the subject of animal rights media attention, and as we expand our service biology offerings into non-GLP toxicology, we anticipate that we will work extensively with large animals and non-human primates. However, research activities with animals have been the subject of adverse attention, negatively impacting our industry. Any negative attention or threats directed against our animal research activities could impair our ability to operate our business efficiently. In addition, if regulatory authorities were to mandate a significant reduction in safety testing procedures that utilize laboratory animals, as has been advocated by certain groups, our business could be materially and adversely affected.

Contamination in our animal populations can distort or compromise the quality of our research results, cause human infection, increase costs and decrease revenue.

Our research models must be free of certain infectious agents such as certain viruses and bacteria. The presence of these infectious agents in our animal facilities could distort or compromise the quality of our research results and could adversely impact human or animal health. Removing or preventing contamination typically requires cleaning, renovating, disinfecting, retesting and restarting our animal facilities, which result in clean-up and start-up costs and reduced revenue due to lost customer confidence in the accuracy of our research results. In some cases, we may import animals carrying infectious agents capable of causing diseases in humans. As a result, there could be a possible risk of human exposure and infection. Although we have not had serious contamination in the past, contamination may occur in the future, which could materially and adversely impact our financial results.

For our customers’ future drugs to be marketed in the United States, we may need to obtain clearance from the FDA and our operations will need to comply with FDA standards. Any adverse action by the FDA against us would negatively impact our ability to offer our services and harm our business and prospects.

As we expand our service offerings, we may need to obtain clearance by the U.S. Food and Drug Administration, or FDA, in the event that our customers’ clinical trials reach the stage of filing a New Drug Application, or NDA, with the FDA, to grant permission to market the drug in the United States. All facilities and manufacturing techniques used to manufacture drugs and biologics in the United States must conform to standards established by the FDA. The FDA may conduct scheduled periodic inspections of our facilities to monitor our compliance with regulatory standards. If the FDA finds that we have failed to comply with the appropriate regulatory standards, it may impose fines or take other actions against us or our customers, or we may no longer be able to offer our services to U.S. customers. The resulting corrective measures may be lengthy and costly. As a result, we may be unable to fulfill our contractual obligations. Any adverse action by the FDA would materially and adversely impact our reputation and our business, financial condition, results of operations and prospects. We may or may not obtain clearance from FDA standards in the event that we are inspected, or maintain such clearance over time.

New technologies or methodologies may be developed, validated and increasingly used in the global pharmaceutical and biotechnology R&D outsourcing industry that could reduce demand for our services.

The global pharmaceutical and biotechnology R&D outsourcing industry is evolving, and we must keep pace with new technologies and methodologies in the industry to maintain our competitive position. As a result, we must invest significant human and capital resources in R&D to enhance our technology and our existing

 

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services and introduce new services utilizing advanced technologies. However, we may not be successful in adapting to or commercializing these new technologies if developed. New technologies could decrease the need for our existing technologies, and we may not be able to develop new service or technologies effectively or in a timely manner. Our failure to develop, enhance or adapt, to new technologies and methodologies could significantly reduce demand for our services and harm our business and prospects.

Our principal facilities may be vulnerable to natural disasters or other unforeseen catastrophic events.

We conduct our operations primarily at our headquarters in Shanghai Zhangjiang Hi-Tech Park and our R&D center in Chengdu. We also have animal facilities in Shanghai Zhangjiang Hi-Tech Park and a manufacturing facility in Nanhui, Shanghai. In addition, we are constructing a cGMP-quality multiple-purpose manufacturing facility and a laboratory services building in Fengxian, Shanghai. We depend on our facilities for our business. Natural disasters or other unanticipated catastrophic events, including power interruptions, water shortage, storms, fires, earthquakes, terrorist attacks and wars could significantly impair our ability to operate our business in its ordinary course. Our facilities and certain equipment located in these facilities would be difficult to replace in any such event and could require substantial replacement time. The occurrence of any such event may materially and adversely affect our business, financial condition, results of operations and prospects.

We face risks related to health epidemics and other outbreaks, which could significantly disrupt our staffing and may even result in temporary closure of our facilities.

Our business could be materially and adversely affected by the outbreak of avian influenza, severe acute respiratory syndrome, or SARS, or another epidemic. In April 2009, a new strain of influenza A virus subtype H1N1 was discovered in North America and quickly spread to other parts of the world, including China. In early June 2009, the World Health Organization declared the outbreak to be a pandemic, while noting that most of the illnesses were of moderate severity. The PRC Ministry of Health has reported a few hundred deaths caused by the influenza A (H1N1). Any outbreak of avian influenza, SARS, the influenza A (H1N1) or other adverse public health developments in China may materially and adversely affect our business operations. These occurrences could severely disrupt to our daily operations.

Risks Related to Doing Business in China

Fluctuations in exchange rates may materially and adversely affect your investment.

The value of the Renminbi against the U.S. dollar and other currencies is affected by, among other things, changes in China’s political and economic conditions and China’s foreign exchange policies. The conversion of the Renminbi into foreign currencies, including the U.S. dollar, has been based on exchange rates set by the People’s Bank of China. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the Renminbi solely to the U.S. dollar. Under this revised policy, the Renminbi is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. Following the removal of the U.S. dollar peg, the Renminbi appreciated approximately 21.5% against the U.S. dollar over the following three years. Since July 2008, however, the Renminbi has traded within a narrow range against the U.S. dollar. As a consequence, the Renminbi has fluctuated significantly since July 2008 against other freely traded currencies, in tandem with the U.S. dollar. On June 20, 2010, the People’s Bank of China announced that the PRC government would further reform the Renminbi exchange rate regime and increase the flexibility of the exchange rate. It is difficult to predict how this new policy may impact the Renminbi exchange rate.

The reporting and functional currency of ShangPharma Corporation is the U.S. dollar. Our offshore subsidiaries’ functional currency is the U.S. dollar. However, the functional currency of our PRC subsidiaries is the Renminbi. A significant majority of our revenues are denominated in U.S. dollars and most of our costs and expenses are denominated in Renminbi. The net proceeds from this offering will be denominated in U.S. dollars.

 

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Fluctuations in exchange rates, primarily those involving the U.S. dollar, may affect the relative purchasing power of these proceeds. In addition, appreciation or depreciation in the value of the Renminbi relative to the U.S. dollar would affect our financial results reported in U.S. dollar terms without giving effect to any underlying change in our business or results of operations. Fluctuations in the exchange rate will also affect the relative value of earnings from and the value of any U.S. dollar-denominated investments we make.

Limited hedging options are available in China to reduce our exposure to exchange rate fluctuations. We began hedging our U.S. dollar exposure using forward contracts from the second half of 2008 based in part on our expected monthly revenues. We may continue to enter similar or other types of hedging transactions in the future. However, the availability and effectiveness of these hedges may be limited and we may not be able to adequately hedge our exposure or at all. In addition, our currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert between the Renminbi and foreign currency. As a result, fluctuations in exchange rates may materially and adversely affect your investment.

Adverse changes in the political and economic policies of the PRC government could materially and adversely affect the overall economic growth of China, which could adversely affect our business.

Substantially all of our assets are located in China and all of our revenues are derived from our operations there. Accordingly, economic, political and legal developments in China significantly affect our business, financial condition, results of operations and prospects. The Chinese economy differs from the economies of most developed countries in many respects, including the amount of government involvement, level of development, growth rate, control of foreign exchange and allocation of resources. While the Chinese economy has grown significantly in the past 30 years, the growth has been uneven across different periods, regions and economic sectors of China. We cannot assure you that the Chinese economy will continue to grow, or that any such growth will be steady and uniform, or that if there is a slowdown, such a slowdown will not have a negative effect on our business.

The PRC government also exercises significant control over China’s economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. From late 2003 to mid-2008, the PRC government implemented a number of measures, such as increasing the People’s Bank of China’s statutory deposit reserve ratio and imposing commercial bank lending guidelines that had the effect of slowing the growth of credit, which in turn may have slowed the growth of the Chinese economy. In response to the recent global and Chinese economic downturn, the PRC government has promulgated several measures aimed at expanding credit and stimulating economic growth. Since August 2008, the People’s Bank of China has decreased the statutory deposit reserve ratio and lowered benchmark interest rates several times. It is unclear whether the PRC government will continue such policies, or whether PRC economic policies will be effective in creating stable economic growth. Any further slowdown in the economic growth of China could reduce demand for our solutions and services, which could materially and adversely affect our business, our financial condition and results of operations.

Uncertainties with respect to the PRC legal system could adversely affect us.

We conduct our business primarily through our PRC subsidiaries. Our operations in China are governed by PRC laws and regulations. Our PRC subsidiaries are foreign-invested enterprises and are subject to laws and regulations applicable to foreign investment in China and, in particular, laws applicable to foreign-invested enterprises. The PRC legal system is largely a civil law system based on written statutes. Unlike the common law system, prior court decisions may be cited for reference but have limited precedential value.

In 1979, the PRC government began to promulgate a comprehensive system of laws and regulations governing general economic matters. The overall effect of legislation over the past two decades has significantly enhanced the protections afforded to various foreign investments in China. However, China has not developed a

 

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fully integrated legal system, and recently enacted laws and regulations may not sufficiently cover all aspects of economic activities in China. Because these laws and regulations are relatively new, and published court decisions are limited and nonbinding in nature, the interpretation and enforcement of these laws and regulations involve uncertainties. In addition, the PRC legal system is based in part on government policies and internal rules, some of which are not published on a timely basis or at all, which may have a retroactive effect. As a result, we may not be aware of our violation of these policies and rules until after the violation occurs.

Any administrative and court proceedings in China may be protracted, resulting in substantial costs and diversion of resources and management attention. However, since PRC administrative and court authorities have significant discretion in interpreting and implementing statutory and contractual terms, it may be more difficult to evaluate the outcome of administrative and court proceedings and the level of legal protection we enjoy than in more developed legal systems. These uncertainties may also impede our ability to enforce the contracts entered into by our PRC subsidiaries. As a result, these uncertainties could materially and adversely affect our business and results of operations.

SAFE regulations may limit our ability to finance our PRC subsidiaries effectively and affect the value of your investment and may make it more difficult for us to pursue growth through acquisition.

If we finance our PRC subsidiaries through additional capital contributions, the Ministry of Commerce in China or its local counterpart must approve the amount of these capital contributions. On August 29, 2008, the State Administration of Foreign Exchange, or SAFE, promulgated Circular 142, a notice regulating the conversion by a foreign-invested company of foreign currency into Renminbi by restricting how the converted Renminbi may be used. The notice requires that Renminbi converted from the foreign currency-denominated capital of a foreign-invested company may only be used for purposes within the business scope approved by the applicable governmental authority and may not be used for equity investments in the PRC unless otherwise provided by laws and regulations. In addition, SAFE strengthened its oversight of the flow and use of Renminbi funds converted from the foreign currency denominated capital of a foreign-invested company. The use of such Renminbi may not be changed without approval from SAFE, and may not be used to repay Renminbi loans if the proceeds of such loans have not yet been used for purposes within the company’s approved business scope. Violations of Circular 142 may result in severe penalties, including substantial fines as set forth in the Foreign Exchange Administration Regulations. We cannot assure you that we will be able to complete the necessary government registrations or obtain the necessary government approvals on a timely basis, if at all, with respect to future loans by us to our PRC subsidiaries or with respect to future capital contributions by us to our PRC subsidiaries. If we fail to complete such registrations or obtain such approvals, our ability to contribute additional capital to fund our PRC operations may be negatively affected, which could adversely and materially affect our liquidity and our ability to fund and expand our business.

PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident beneficial owners or our PRC subsidiaries to liability or penalties, limit our ability to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to increase their registered capital or distribute profits to us, or may otherwise adversely affect us.

On October 21, 2005, SAFE issued a public circular, or Circular 75, which became effective on November 1, 2005. Circular 75 requires PRC residents to register with the local SAFE branch before establishing or controlling any company, referred to in the circular as an “offshore special purpose vehicle,” outside of the PRC for capital financing and to register again after completing an investment in or acquisition of any operating subsidiaries in the PRC, which is commonly referred to as a round-trip investment. Also, any change of shareholding or any other material capital alteration in such offshore special purpose vehicle shall be filed with the local SAFE branch within 30 days after the shareholding change or capital alteration.

In 2003, our founders, who may be deemed PRC residents for the purpose of Circular 75, established our intermediary holding companies in Hong Kong, which subsequently acquired or established their directly-owned subsidiaries in China. Circular 75 retroactively applies to our initial formation of the corporate structure

 

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as a round-trip investment and required our founders to register their respective shareholdings in our company with the local SAFE branch in Shanghai by March 31, 2006. Our founders inadvertently missed this filing deadline. We have urged our founders to, and they have been making efforts in order to, apply for a remedial SAFE registration. Although such a remedial registration is permissible under supplementary rules of Circular 75, our founders’ attempted registration has not been accepted by the local SAFE branch in Shanghai due to the lack of specific administrative procedures for remedial registrations. We will continue to urge our founders to, and our founders will continue making efforts to, apply for a remedial SAFE registration. However, we cannot assure you that our founders will be able to make the remedial registration. If for any reason the relevant government authorities in China determine that our founders are not in compliance with Circular 75, our founders may be subject to administrative measures and penalties, such as orders to rectify and monetary fines, and any proposed foreign exchange transaction between our Hong Kong intermediary holding companies and their directly owned subsidiaries in China may be restricted, which may materially and adversely affect our business operations and liquidity in China.

Failure to comply with PRC regulations regarding the registration requirements for employee stock ownership plans or share option plans may subject the PRC plan participants or us to fines and other legal or administrative sanctions.

Under applicable PRC regulations, all foreign exchange matters relating to employee stock ownership plans, share option plans or similar plans in which Chinese citizens participate require approval from SAFE or its authorized local branch. In addition, Chinese citizens who are granted share options, shares or other equity interests such as RSUs by an offshore listed company are required, through a Chinese agent or Chinese subsidiary of the offshore listed company, to register with SAFE and complete certain other procedures. We will become an offshore listed company upon the completion of this offering and as a result we and our Chinese employees who have been granted share options, RSUs or shares will be subject to, and intend to comply with, these regulations. If we or our Chinese employees fail to comply with these regulations after we become an offshore listed company, we or our Chinese employees may face sanctions imposed by SAFE or other PRC government authorities, including restrictions on foreign currency conversions and additional capital contributions to our PRC subsidiaries.

We rely principally on dividends and other distributions on equity paid by our subsidiaries to fund any cash and financing requirements we may have, and any limitation on the ability of our subsidiaries entities to make payments to us could materially and adversely affect our ability to conduct our business.

We are a holding company and we rely principally on dividends from our subsidiaries in Hong Kong for our cash requirements, including any debt we may incur. We currently receive substantially all of our revenues in U.S. dollars. In future periods, however, we expect to receive an increasing portion of our revenues in RMB. Current PRC regulations permit our subsidiaries to pay dividends to us only out of their accumulated profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, each of our subsidiaries in China is required to set aside a certain amount of its after-tax profits each year, if any, to fund certain statutory reserves. These reserves are not distributable as cash dividends. As of December 31, 2009, our aggregate net assets in the amount of $5.4 million were not distributable in the form of dividends to us due to these PRC regulations. Furthermore, if our subsidiaries in China incur debt, the instruments governing the debt may restrict their ability to pay dividends or make other payments to us. In addition, the PRC tax authorities may require us to adjust our taxable income under the contractual arrangements we have in place in a manner that would materially and adversely affect our subsidiaries’ ability to pay dividends and other distributions to us. Any limitation on the ability of our subsidiaries to distribute dividends or other payments to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our businesses, pay dividends or otherwise fund and conduct our business.

 

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The discontinuation, reduction or delay of any of the preferential tax treatment or other government incentives available to us in the PRC or imposition of any additional PRC taxes on us could adversely affect our financial condition and results of operations.

China has passed a new PRC Enterprise Income Tax Law and its implementing rules, both of which became effective on January 1, 2008. The PRC Enterprise Income Tax Law significantly curtails tax incentives granted to foreign-invested enterprises under the Foreign-Invested Enterprise Income Tax Law in effect before January 1, 2008. The PRC Enterprise Income Tax Law, however, (i) reduces the statutory rate of the enterprise income tax from 33% to 25%, (ii) permits companies established before March 16, 2007 to continue to enjoy their existing tax incentives, adjusted by certain transitional phase-out rules promulgated by the State Council on December 26, 2007, and (iii) introduces new tax incentives, subject to various qualification criteria.

The PRC Enterprise Income Tax Law and its implementing rules permit certain “high and new technology enterprises” which hold independent ownership of core intellectual property and simultaneously meet a list of other criteria, to enjoy a reduced 15% enterprise income tax rate subject to certain new qualification criteria. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Income Taxes.”

In addition, local governments have used different incentives to encourage or accelerate the development of pharmaceutical and biotechnology R&D outsourcing industries. We have historically received sales tax exemptions for certain laboratory services upon approval from local authorities. We also benefited from government incentives in the form of cash subsidies in 2008 and 2009.

Preferential tax treatment and other government incentives granted to our subsidiaries by local governmental authorities are subject to review and may be adjusted or revoked at any time. The discontinuation of any preferential tax treatment or other government incentives available to us and our wholly-owned PRC subsidiaries will cause our effective tax rate to increase or our other income to decrease, which could materially and adversely affect our financial condition and results of operations.

Our global income and the dividends that we may receive from our PRC subsidiaries may be subject to PRC taxes under the PRC Enterprise Income Tax Law, which would materially and adversely affect our results of operations.

Under the PRC Enterprise Income Tax Law and its implementing rules, both effective from January 1, 2008, an enterprise established outside of the PRC with “de facto management bodies” within the PRC is considered a resident enterprise and will be subject to the enterprise income tax at the rate of 25% on its global income. The implementation rules define the term “de facto management bodies” as “establishments that carry out substantial and overall management and control over the manufacturing and business operations, personnel, accounting, properties, etc. of an enterprise.” The State Tax Administration issued the Notice Regarding the Determination of Chinese-Controlled Offshore Incorporated Enterprises as PRC Tax Resident Enterprises on the Basis of De Facto Management Bodies, or SAT Circular 82, on April 22, 2009. SAT Circular 82 provides certain criteria for determining whether the “de facto management body” of an offshore-incorporated enterprise controlled by PRC enterprises is located in China.

Although SAT Circular 82 only applies to offshore enterprises controlled by PRC enterprises and not those controlled by PRC or foreign individuals or foreign enterprises, the criteria set forth therein may reflect State Tax Administration’s general position on how the “de facto management body” test should be applied in determining the tax resident status of offshore enterprises, regardless of whether they are controlled by PRC or foreign enterprises or individuals. Accordingly, we may be considered a resident enterprise and may therefore be subject to the enterprise income tax at 25% on our global income other than dividends from our PRC subsidiaries, which could significantly increase our tax burden and materially and adversely affect our cash flow and profitability.

Under the applicable PRC tax laws in effect before January 1, 2008, dividend payments to foreign investors made by foreign-invested enterprises in China, such as our PRC subsidiaries, were exempt from PRC

 

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withholding tax. However, our PRC counsel, Fangda Partners, has advised us that pursuant to the PRC Enterprise Income Tax Law, dividends generated after January 1, 2008 and payable by a foreign-invested enterprise in China to its foreign investors that are not PRC resident enterprises will be subject to a 10% withholding tax, unless any such foreign investor’s jurisdiction of incorporation has a tax treaty with China that provides for a different withholding arrangement. We are a Cayman Islands holding company and substantially all of our income may come from dividends we receive from our subsidiaries located in Hong Kong, which are the direct holding companies of our PRC subsidiaries. If our Hong Kong subsidiaries are considered non-PRC resident enterprises, dividends that they receive from our PRC subsidiaries may be subject to withholding tax at a preferential rate of no more than 5% under the Arrangement between the PRC and the Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion, effective on January 1, 2007, upon receiving approval from the local tax authority. However, if our Hong Kong subsidiaries are not considered to be the beneficial owners of our PRC subsidiaries under a tax notice promulgated on October 27, 2009, such dividends would be subject to withholding tax at a rate of 10%. See “Regulation—Regulations on Tax—Dividend Withholding Tax.”

According to our PRC counsel, Fangda Partners, because there remains uncertainty regarding the interpretation and implementation of the PRC Enterprise Income Tax Law and its implementation rules, it is uncertain whether, if we are regarded as a PRC resident enterprise, any dividends to be distributed by us to our non-PRC shareholders and ADS holders would be subject to any PRC withholding tax. If we are required under the PRC Enterprise Income Tax Law to withhold PRC income tax on our dividends payable to our non-PRC enterprise shareholders and ADS holders, your investment in our ordinary shares or ADSs may be materially and adversely affected.

We face uncertainty with respect to indirect transfers of equity interests in PRC resident enterprises by their non-PRC holding companies.

Pursuant to the Notice on Strengthening Administration of Enterprise Income Tax for Share Transfers by Non-PRC Resident Enterprises, or SAT Circular 698, issued by the State Administration of Taxation on December 10, 2009 with retroactive effect from January 1, 2008, where a non-resident enterprise transfers the equity interests of a PRC resident enterprise indirectly via disposing of the equity interests of an overseas holding company, or an Indirect Transfer, and such overseas holding company is located in a tax jurisdiction that: (i) has an effective tax rate less than 12.5% or (ii) does not tax foreign income of its residents, the foreign investor shall report to the competent tax authority of the PRC resident enterprise this Indirect Transfer. Using a “substance over form” principle, the PRC tax authority may disregard the existence of the overseas holding company if it lacks a reasonable commercial purpose and was established for the purpose of avoiding PRC tax. As a result, gains derived from such Indirect Transfer may be subject to PRC withholding tax at a rate of up to 10%. SAT Circular 698 also provides that, where a non-PRC resident enterprise transfers its equity interests in a PRC resident enterprise to its related parties at a price lower than the fair market value, the relevant tax authority has the power to make a reasonable adjustment to the taxable income of the transaction.

There is uncertainty as to the application of SAT Circular 698. For example, while the term “Indirect Transfer” is not clearly defined, it is understood that the relevant PRC tax authorities have jurisdiction regarding requests for information over a wide range of foreign entities having no direct contact with China. Moreover, the relevant authority has not yet promulgated any formal provisions or formally declared or stated how to calculate the effective tax rates in foreign tax jurisdictions, and the process and format of the reporting of an Indirect Transfer to the competent tax authority of the relevant PRC resident enterprise. In addition, there are not any formal declarations with regard to how to determine whether a foreign investor has adopted an abusive arrangement in order to avoid PRC tax. As a result, we may become at risk of being taxed under SAT Circular 698 and we may be required to expend valuable resources to comply with SAT Circular 698 or to establish that we should not be taxed under SAT Circular 698, which may have a material adverse effect on our financial condition and results of operations.

 

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The approval of the China Securities Regulatory Commission may be required in connection with this offering under a regulation adopted in August 2006, and, if required, we cannot predict whether we will be able to obtain such approval.

In 2006, six PRC regulatory agencies jointly adopted the Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, or the M&A Rule. This rule requires that, if an overseas company established or controlled by PRC domestic companies or citizens intends to acquire equity interests or assets of any other PRC domestic company affiliated with the PRC domestic companies or citizens, such acquisition must be submitted to the Ministry of Commerce, rather than local regulators, for approval. In addition, this regulation requires that an overseas company controlled directly or indirectly by PRC companies or citizens and holding equity interests of PRC domestic companies must obtain the approval of the China Securities Regulatory Commission, or CSRC, prior to listing its securities on an overseas stock exchange. On September 21, 2006, the CSRC published a notice on its official website specifying the documents and materials required to be submitted by overseas special purpose companies seeking CSRC’s approval of their overseas listings.

While the application of the M&A Rule remains unclear, based on their understanding of current PRC laws, regulations, and the notice published on September 21, 2006, our PRC counsel, Fangda Partners, has advised us that, we are not required to submit an application to the Ministry of Commerce or the CSRC for its approval for the listing and trading of our ADSs on the New York Stock Exchange because our PRC subsidiaries were either converted into wholly foreign owned enterprises prior to September 8, 2006, the effective date of the M&A rule, or incorporated as wholly foreign owned enterprises.

Fangda has further advised us that their opinions summarized above are subject to the timing and content of any new laws, rules and regulations or clearer implementation and interpretations from the Ministry of Commerce and CSRC in any form relating to the M&A Rule.

If the CSRC or another PRC regulatory agency subsequently determines that CSRC approval was required for this offering, we may need to apply for a remedial approval from the CSRC and may be subject to certain administrative punishments or other sanctions from PRC regulatory agencies. The regulatory agencies may impose fines and penalties on our operations in the PRC, limit our operating privileges in the PRC, delay or restrict the repatriation of our foreign currency in our offshore bank accounts into the PRC, or take other actions that could materially and adversely affect our business, financial condition, results of operations, reputation and prospects, as well as the trading price of our ADSs.

Also, if the CSRC later requires that we obtain its approval, we may be unable to obtain a waiver of the CSRC approval requirements, if and when procedures are established to obtain such a waiver. Any uncertainties or negative publicity regarding these CSRC approval requirements could materially and adversely affect the trading price of our ADSs.

The M&A Rule sets forth complex procedures for acquisitions conducted by foreign investors that could make it more difficult to pursue acquisitions.

The M&A Rule sets forth complex procedures and requirements that could make merger and acquisition activities by foreign investors more time-consuming and complex, including requirements in some instances that the Ministry of Commerce be notified in advance of any change-of-control transaction in which a foreign investor takes control of a PRC domestic enterprise. Complying with the requirements of the M&A Rule to complete such transactions could be time-consuming, and any required approval processes, including obtaining approval from the Ministry of Commerce, may delay or inhibit our ability to complete such transactions, which could affect our ability to expand our business or maintain our market share.

 

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The failure of the owners of our leased facilities to comply with PRC property related laws and other matters may materially and adversely affect our ability to use our R&D facilities.

We perform various R&D services in leased facilities in Shanghai and Chengdu. The owners of our leased facilities have not met a number of land- and property-related legal requirements. For example, owners of some of our leased facilities have not been able to provide us with relevant building ownership certificates. Certain properties leased by us are used for R&D purposes while they are under zoning restrictions to be used for industrial or other purposes. In addition, certain leased facilities have been mortgaged by their respective owners. As a result, third parties or government authorities may interfere with the use of our leased properties, we may be subject to fines by the government, our leases may be invalidated and our rights under these leases may be adversely affected. We may be forced to relocate any affected facilities. All of these consequences could materially and adversely affect our business, financial condition, results of operations and prospects.

Risks Related to this Offering

There has been no public market for our shares or ADSs prior to this offering, and you may not be able to resell our ADSs at or above the price you paid, or at all.

Prior to this offering, there has been no public market for our shares or ADSs. Our ADSs have been approved for listing on the New York Stock Exchange. Our ordinary shares will not be listed on any exchange or quoted for trading on any over-the-counter trading system. If an active trading market for our ADSs does not develop after this offering, the market price and liquidity of our ADSs will be materially and adversely affected.

Negotiations with the underwriters will determine the initial public offering price for our ADSs which may bear no relationship to their market price after this offering. We cannot assure you that an active trading market for our ADSs will develop or that the market price of our ADSs will remain at or above the initial public offering price.

The market price for our ADSs may be volatile.

The market price for our ADSs is likely to be highly volatile and subject to wide fluctuations in response to factors including the following:

 

   

regulatory developments in our target markets affecting us, our customers or our competitors;

 

   

announcements of studies and reports relating to the quality of our solutions and services or those of our competitors;

 

   

changes in the economic performance or market valuations of other companies that provide pharmaceutical and biotechnology R&D outsourcing services;

 

   

actual or anticipated fluctuations in our quarterly results of operations and changes or revisions of our expected results;

 

   

changes in financial estimates by securities research analysts;

 

   

conditions in the pharmaceutical and biotechnology R&D outsourcing services industry;

 

   

announcements by us or our competitors of new services, acquisitions, strategic relationships, joint ventures or capital commitments;

 

   

additions to or departures of our senior management;

 

   

fluctuations of exchange rates between the Renminbi and the U.S. dollar;

 

   

release or expiration of lock-up or other transfer restrictions on our outstanding ordinary shares or ADSs; and

 

   

sales or perceived potential sales of additional ordinary shares or ADSs.

 

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In addition, the securities market has experienced significant price and volume fluctuations unrelated to the operating performance of any particular companies. These market fluctuations may also materially and adversely affect the market price of our ADSs.

Because our initial public offering price is substantially higher than our net tangible book value per share, you will experience immediate and substantial dilution.

If you purchase ADSs in this offering, you will pay more for your ADSs than the amount paid by our existing shareholders for their ordinary shares on a per ADS basis. As a result, you will experience immediate and substantial dilution of approximately $9.52 per ADS, representing the difference between the initial public offering price of $15.00 per ADS and our net tangible book value per ADS as of June 30, 2010, after giving effect to the automatic conversion of our preferred shares, immediately upon the completion of this offering and net proceeds to us from this offering. In addition, you may experience further dilution to the extent that our ordinary shares are issued upon the exercise of share options.

Because we do not expect to pay dividends in the foreseeable future after this offering, you must rely on price appreciation of our ADSs for return on your investment.

We intend to retain most, if not all, of our available funds and earnings after this offering to fund the development and growth of our business. As a result, we do not expect to pay any cash dividends in the foreseeable future. Therefore, you should not rely on an investment in our ADSs as a source for any future dividend income.

Our board of directors has significant discretion as to whether to distribute dividends. Even if our board of directors decides to declare and pay dividends, the timing, amount and form of future dividends, if any, will depend on, among other things, our future results of operations and cash flow, our capital requirements and surplus, the amount of distributions, if any, received by us from our subsidiaries, our financial condition, contractual restrictions and other factors deemed relevant by our board of directors. Accordingly, the return on your investment in our ADSs will likely depend entirely upon any future price appreciation of our ADSs. There is no guarantee that our ADSs will appreciate in value after this offering or even maintain the price at which you purchased the ADSs. You may not realize a return on your investment in our ADSs and you may even lose your entire investment in our ADSs.

Substantial future sales or perceived potential sales of our ADSs in the public market could cause the price of our ADSs to decline.

Sales of our ADSs or ordinary shares in the public market after this offering, or the perception that these sales could occur, could cause the market price of our ADSs to decline. Upon completion of this offering, we will have 335,600,000 ordinary shares outstanding including 104,400,000 ordinary shares represented by ADSs. All ADSs sold in this offering will be freely transferable without restriction or additional registration under the United States Securities Act of 1933, as amended, or the Securities Act, unless held by our “affiliates” as that term is defined in Rule 144 under the Securities Act. The remaining ordinary shares outstanding after this offering will be available for sale, upon the expiration of the 180-day lock-up period beginning from the date of this prospectus, subject to volume and other restrictions as applicable under Rules 144 and 701 under the Securities Act. Any or all of these shares may be released prior to the expiration of the lock-up period at the discretion of the representatives. To the extent shares are released before the expiration of the lock-up period and sold into the market, the market price of our ADSs could decline.

Upon completion of this offering, certain holders of our ordinary shares will have the right to cause us to register under the Securities Act the sale of their shares, subject to the 180-day lock-up period in connection with

 

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this offering. Registration of these shares under the Securities Act would result in ADSs representing these shares becoming freely tradable without restriction under the Securities Act immediately upon the effectiveness of the registration. Sales of these registered shares in the form of ADSs, in the public market could cause the price of our ADSs to decline.

You may not have the same voting rights as the holders of our ordinary shares and may not receive voting materials in time to be able to exercise your right to vote.

Except as described in this prospectus and in the deposit agreement, holders of our ADSs will not be able to exercise voting rights attaching to the shares represented by our ADSs on an individual basis. Holders of our ADSs will appoint the depositary or its nominee as their representative to exercise the voting rights attaching to the shares represented by the ADSs. You may not receive voting materials in time to instruct the depositary to vote, and it is possible that you, or persons who hold their ADSs through brokers, dealers or other third parties, will not have the opportunity to exercise a right to vote.

Your right to participate in any rights offerings may be limited, which may cause dilution to your holdings, and you may not receive cash dividends if it is impractical to make them available to you.

We may from time to time distribute rights to our shareholders, including rights to acquire our securities. However, we cannot make rights available to you in the United States unless we register both the rights and the securities to which the rights relate under the Securities Act or an exemption from the registration requirements is available. Under the deposit agreement, the depositary will not make rights available to you unless both the rights and the underlying securities to be distributed to ADS holders are either registered under the Securities Act or exempt from registration under the Securities Act. We are under no obligation to file a registration statement with respect to any such rights or securities or to endeavor to cause such a registration statement to be declared effective and we may not be able to establish a necessary exemption from registration under the Securities Act. Accordingly, you may be unable to participate in our rights offerings and may experience dilution in your holdings.

The depositary of our ADSs has agreed to pay to you the cash dividends or other distributions it or the custodian receives on our ordinary shares or other deposited securities after deducting its fees and expenses. You will receive these distributions in proportion to the number of ordinary shares your ADSs represent. However, the depositary may, at its discretion, decide that it is inequitable or impractical to make a distribution available to any holders of ADSs. For example, the depositary may determine that it is not practicable to distribute certain property through the mail, or that the value of certain distributions may be less than the cost of mailing them. In these cases, the depositary may decide not to distribute such property to you.

You may be subject to limitations on transfer of your ADSs.

Your ADSs are transferable on the books of the depositary. However, the depositary may close its transfer books at any time or from time to time when it deems expedient in connection with the performance of its duties. In addition, the depositary may refuse to deliver, transfer or register transfers of ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary deems it advisable to do so because of any requirement of law or of any government or governmental body, or under any provision of the deposit agreement, or for any other reason.

You may face difficulties in protecting your interests, and your ability to protect your rights through the U.S. federal courts may be limited because we are incorporated under Cayman Islands law, we conduct substantially all of our operations in China and all of our directors and officers reside outside the United States.

We are incorporated in the Cayman Islands and conduct substantially all of our operations in China through our PRC subsidiaries. All of our directors and officers reside outside the United States and a substantial

 

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portion of their assets are located outside of the United States. As a result, it may be difficult or impossible for you to bring an action against us or against these individuals in the Cayman Islands or in China in the event that you believe that your rights have been infringed under the securities laws or otherwise. Even if you are successful in bringing an action of this kind, the laws of the Cayman Islands and of China may render you unable to enforce a judgment against our assets or the assets of our directors and officers.

There is no statutory recognition in the Cayman Islands of judgments obtained in the United States, although the courts of the Cayman Islands will recognize as a valid judgment, a final and conclusive judgment in personam obtained in a federal or state court of the United States under which a sum of money is payable (other than a sum of money payable in respect of multiple damages, taxes or other charges of a like nature or in respect of a fine or other penalty) and would give a judgment based thereon; provided that (a) such courts had proper jurisdiction over the parties subject to such judgment; (b) such courts did not contravene the rules of natural justice of the Cayman Islands; (c) such judgment was not obtained by fraud; (d) the enforcement of the judgment would not be contrary to the public policy of the Cayman Islands; (e) no new admissible evidence relevant to the action is submitted prior to the rendering of the judgment by the courts of the Cayman Islands; and (f) there is due compliance with the correct procedures under the laws of the Cayman Islands. For more information regarding the relevant laws of the Cayman Islands and China, see “Enforceability of Civil Liabilities.”

Our corporate affairs are governed by our memorandum and articles of association, as amended and restated from time to time, and by the Companies Law (2010 Revision) and common law of the Cayman Islands. The rights of shareholders to take legal action against us and our directors, actions by minority shareholders and the fiduciary responsibilities of our directors are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, which provides persuasive, but not binding, authority on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedents in the United States. In particular, the Cayman Islands has a less developed body of securities laws than the United States and provides significantly less protection. In addition, Cayman Islands companies may not have standing to initiate a shareholder derivative action in U.S. federal courts.

As a result, our public shareholders may have more difficulty in protecting their interests through actions against us, our management, our directors or our major shareholders than would shareholders of a corporation incorporated in a jurisdiction in the United States.

You must rely on the judgment of our management as to the use of the net proceeds from this offering, and such use may not produce income or increase our ADS price.

We have not allocated a significant portion of the net proceeds of this offering to any particular purpose. Rather, our management will have considerable discretion in the application of the net proceeds received by us. You will not have the opportunity, as part of your investment decision, to assess whether proceeds are being used appropriately. You must rely on the judgment of our management regarding the application of the net proceeds of this offering. The net proceeds may be used for corporate purposes that do not improve our efforts to maintain profitability or increase our ADS price. The net proceeds from this offering may be placed in investments that do not produce income or that lose value.

Our memorandum and articles of association will contain anti-takeover provisions that could adversely affect the rights of holders of our ordinary shares and ADSs.

We have adopted a second amended and restated memorandum and articles of association that will become effective immediately upon the completion of this offering. Our new memorandum and articles of association will contain certain provisions that could limit the ability of others to acquire control of our company, including a provision that grants authority to our board of directors to establish from time to time one or more series of preferred shares without action by our shareholders and to determine, with respect to any series of

 

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preferred shares, the terms and rights of that series. The provisions could have the effect of depriving our shareholders of the opportunity to sell their shares, including shares represented by ADSs, at a premium over the prevailing market price by discouraging third parties from seeking to obtain control of our company in a tender offer or similar transactions.

Our corporate actions are substantially controlled by our directors, executive officers and other principal shareholders, who can exert significant influence over important corporate matters, which may reduce the price of our ADSs and deprive you of an opportunity to receive a premium for your ADSs.

After this offering, our directors, executive officers and principal shareholders will beneficially own approximately 66.9% of our outstanding ordinary shares. These shareholders, if acting together, could exert substantial influence over matters such as electing directors and approving material mergers, acquisitions or other business combination transactions. This concentration of ownership may also discourage, delay or prevent a change in control of our company, which could have the dual effect of depriving our shareholders of an opportunity to receive a premium for their shares as part of a sale of our company and reducing the price of our ADSs. These actions may be taken even if they are opposed by our other shareholders, including those who purchase ADSs in this offering. In addition, these persons could divert business opportunities away from us to themselves or others.

We may be classified as a passive foreign investment company for United States federal income tax purposes, which could subject United States investors in the ADSs or ordinary shares to significant adverse United States federal income tax consequences.

Depending upon the value of our ordinary shares and ADSs and the nature of our assets and income over time, we could be classified as a “passive foreign investment company,” or PFIC, for U.S. federal income tax purposes. A non-United States corporation will be treated as a PFIC for any taxable year if either (i) 75% or more of its gross income for such year consists of certain types of “passive” income, or (ii) 50% or more of the value of its assets (determined on the basis of a quarterly average) during such year is attributable to assets that produce passive income or are held for the production of passive income, or the asset test. Passive income is any income that would be foreign personal holding company income under the Internal Revenue Code of 1986, as amended, including, without limitation, dividends, interest, royalties, rents, annuities, net gains from the sale or exchange of property producing such income, net gains from commodity transactions, net foreign currency gains and income from notional principal contracts.

Based on our current income and assets and projections as to the value of our ordinary shares and ADSs pursuant to this offering, we do not expect to be classified as a PFIC for the current taxable year or the foreseeable future. While we do not anticipate becoming a PFIC, because the value of our assets for purposes of the asset test will generally be determined by reference to the market price of our ADSs or ordinary shares, fluctuations in the market price of our ADSs or ordinary shares may cause us to become a PFIC for the current or subsequent taxable years. Because there are uncertainties in the application of the relevant rules and PFIC status is a factual determination made annually after the close of each taxable year on the basis of the composition of our income and the value of our active versus passive assets, there can be no assurance that we will not be a PFIC for the taxable year 2010 or any future taxable year.

We have not sought a ruling from the United States Internal Revenue Service, or the IRS, with respect to our PFIC status, and there can be no assurance that the IRS will agree with our determination. The overall level of our passive assets will be affected by (i) future growth in activities that may potentially produce passive income, and (ii) how, and how quickly, we spend our liquid assets and the cash raised in this offering. Under circumstances where revenues from activities that produce passive income significantly increase relative to our revenues from activities that produce non-passive income or where we determine not to deploy significant amounts of cash for active purposes, our risk of becoming classified as a PFIC may substantially increase.

If we were to be or become classified as a PFIC, a U.S. Holder (as defined in “Taxation—Material United States Federal Income Tax Considerations—General”) may incur significantly increased United States income tax on gain recognized on the sale or other disposition of the ADSs or ordinary shares and on the receipt of distributions on the ADSs or ordinary shares to the extent such gain or distribution is treated as an “excess

 

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distribution” under the United States federal income tax rules. Further, if we are classified as a PFIC for any year during which a U.S. Holder holds our ADSs or ordinary shares, we generally will continue to be treated as a PFIC for all succeeding years during which such U.S. Holder holds our ADSs or ordinary shares. We urge you to consult your tax advisor concerning the United States federal income tax consequences of acquiring, holding and disposing of ADSs or ordinary shares if we are or become classified as a PFIC. For more information, see “Taxation—Material United States Federal Income Tax Considerations—Passive Foreign Investment Company Considerations.”

We will incur increased costs as a result of being a public company.

As a public company, we will incur significant accounting, legal and other expenses that we did not incur as a private company. The Sarbanes-Oxley Act, as well as rules subsequently implemented by the Securities and Exchange Commission and the New York Stock Exchange, have detailed requirements concerning corporate governance practices of public companies, including Section 404 relating to internal controls over financial reporting. We expect these and other rules and regulations applicable to public companies to increase our accounting, legal and financial compliance costs and to make certain corporate activities more time-consuming and costly. We are evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate the additional costs we may incur or the timing of such costs.

 

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FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements that reflect our current expectations and views of future events. The forward looking statements are contained principally in the sections entitled “Prospectus Summary,” “Risk Factors,” “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” Known and unknown risks, uncertainties and other factors, including those listed under “Risk Factors,” may cause our actual results, performance or achievements to be materially different from those expressed or implied by the forward-looking statements.

You can identify some of these forward-looking statements by words or phrases such as “may,” “will,” “expect,” “anticipate,” “aim,” “estimate,” “intend,” “plan,” “believe,” “likely to,” “potential,” “continue” or other similar expressions. We have based these forward-looking statements largely on our current expectations and projections about future events that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements include statements relating to:

 

   

our goals and strategies;

 

   

our future development, financial condition and results of operations;

 

   

the expected growth of the pharmaceutical and biotechnology outsourcing industry in China and globally;

 

   

market acceptance of our services;

 

   

our expectations regarding demand for our services;

 

   

our ability to stay abreast of market trends and technological advances;

 

   

our ability to effectively protect our customers’ intellectual property rights and not infringe on the intellectual property rights of others;

 

   

competition in the pharmaceutical and biotechnology outsourcing industry;

 

   

PRC and U.S. governmental policies and regulations relating to the pharmaceutical and biotechnology outsourcing industry;

 

   

litigation and government proceedings involving our company and industry; and

 

   

general economic and business conditions, particularly in the United States and China.

These forward-looking statements involve various risks and uncertainties. Although we believe that our expectations expressed in these forward-looking statements are reasonable, our expectations may later be found to be incorrect. Our actual results could be materially different from our expectations. Important risks and factors that could cause our actual results to be materially different from our expectations are generally set forth in “Prospectus Summary—Our Challenges,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business,” “Regulation” and other sections in this prospectus. You should read this prospectus and the documents that we refer to in this prospectus and have filed as exhibits to the registration statement, of which this prospectus is a part, completely and with the understanding that our actual future results may be materially different from what we expect. We qualify all of our forward-looking statements by these cautionary statements.

The forward-looking statements made in this prospectus relate only to events or information as of the date on which the statements are made in this prospectus. Except as required by law, we undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise, after the date on which the statements are made or to reflect the occurrence of unanticipated events.

 

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Market Data and Forecasts

Unless otherwise indicated, information in this prospectus concerning economic conditions and our industry is based on information from independent industry analysts and publications, as well as our estimates. Except where otherwise noted, our estimates are derived from publicly available information released by third-party sources, as well as data from our internal research, and are based on such data and our knowledge of our industry, which we believe to be reasonable.

This prospectus also contains data related to the global and Chinese pharmaceutical and biotechnology R&D outsourcing industries. These market data include estimates and projections that are based on a number of assumptions. If any one or more of the assumptions underlying the market data turn out to be incorrect, actual results may differ significantly from the projections. For example, the global and Chinese pharmaceutical and biotechnology R&D outsourcing markets may not grow at the rate projected by market data, or at all. In addition, the rapidly changing nature of the pharmaceutical and biotechnology R&D outsourcing industry subjects any projections or estimates relating to the growth prospects or future condition of our market to significant uncertainties.

 

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USE OF PROCEEDS

We estimate that we will receive net proceeds from this offering of approximately $41.0 million after deducting underwriting discounts and the estimated offering expenses payable by us. We will not receive any proceeds from the ADSs sold by the selling shareholders.

We plan to use the net proceeds of this offering as follows:

 

   

approximately $15.0 million for the construction of our manufacturing facility and laboratory services building in Fengxian, Shanghai;

 

   

approximately $15.0 million for the purchase of equipment;

 

   

approximately $5.0 million for the expansion of our service offerings;

 

   

approximately $5.0 million for working capital needs; and

 

   

the balance for other general corporate purposes, including potential acquisitions (although we are not currently negotiating any such acquisitions).

The foregoing represents our current intentions based upon our present plans and business conditions to use and allocate the net proceeds of this offering. Our management, however, will have significant flexibility and discretion to apply the net proceeds of this offering. If an unforeseen event occurs or business conditions change, we may use the proceeds of this offering differently than as described in this prospectus. See “Risk Factors—Risks Related to this Offering—You must rely on the judgment of our management as to the use of the net proceeds from this offering, and such use may not produce income or increase our ADS price.”

Pending any use of the net proceeds, as described above, we plan to invest the net proceeds in short-term, interest-bearing debt instruments or bank deposits. These investments may materially and adversely affect the U.S. federal income tax consequences of your investment in our ADSs. In particular, it is possible that we may become a passive foreign investment company for U.S. federal income tax purposes, which could result in negative tax consequences for you. See “Risk Factors—Risks Relating to this Offering—We may be classified as a passive foreign investment company for United States federal income tax purposes, which could subject United States investors in the ADSs or ordinary shares to significant adverse United States federal income tax consequences” and “Taxation—U.S. Federal Income Taxation—U.S. Holders—Passive Foreign Investment Company.”

In using the proceeds from this offering, as an offshore holding company, we are permitted, under PRC laws and regulations, to provide funding to our PRC subsidiaries only through loans or capital contributions. Subject to satisfaction of applicable government registration and approval requirements, we may extend inter-company loans to our PRC subsidiaries or make additional capital contributions to our PRC subsidiaries to fund their capital expenditures or working capital. We cannot assure you that we will be able to obtain these government registrations or approvals on a timely basis, if at all. See “Risk Factors—Risks Related to Doing Business in China—PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident beneficial owners or our PRC subsidiaries to liability or penalties, limit our ability to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to increase their registered capital or distribute profits to us, or may otherwise adversely affect us.”

 

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DIVIDEND POLICY

We do not have any present plan to pay any cash dividends on our ordinary shares in the foreseeable future after this offering. We currently intend to retain most, if not all, of our available funds and any future earnings to operate and expand our business.

Our board of directors has significant discretion on whether to distribute dividends. Even if our board of directors decides to pay dividends, the form, frequency and amount will depend upon our future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and other factors that the board of directors may deem relevant. If we pay any dividends, the depositary will distribute such payments to our ADS holders to the same extent as holders of our ordinary shares, subject to the terms of the deposit agreement, including the fees and expenses payable thereunder. See “Description of American Depositary Shares.” Cash dividends on our ordinary shares, if any, will be paid in U.S. dollars.

 

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CAPITALIZATION

The following table sets forth our capitalization as of June 30, 2010:

 

   

on an actual basis;

 

   

on a pro forma basis to reflect the automatic conversion of all of our outstanding preferred shares into 69,994,014 ordinary shares immediately upon the completion of this offering; and

 

   

on a pro forma as adjusted basis to reflect the automatic conversion of all of our outstanding preferred shares into 69,994,014 ordinary shares immediately upon the completion of this offering, and the sale of 57,600,000 ordinary shares in the form of ADSs by us in this offering at the initial public offering price of $15.00 per ADS, after deducting the underwriting discounts and commissions and estimated offering expenses payable by us.

You should read this table together with our consolidated financial statements and the related notes included elsewhere in this prospectus and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

     As of June 30, 2010  
     Actual      Pro Forma      Pro Forma
As Adjusted
 
     (in millions of $)  

Series A convertible redeemable preferred shares ($0.001 par value; 70,000,650 shares authorized; 69,994,014 shares issued and outstanding; none outstanding on a pro forma basis and a pro forma as adjusted basis)(1)

     34.4                   

Equity:

        

Ordinary shares ($0.001 par value, 429,999,350 shares authorized, 208,005,986 shares issued and outstanding; 278,000,000 shares outstanding on a pro forma basis; 335,600,000 shares outstanding on a pro forma as adjusted basis)(1)

     0.2         0.3         0.3   

Additional paid-in capital

     0.7         35.0         76.0   

Statutory reserves

     5.4         5.4         5.4   

Retained earnings

     18.9         18.9         18.9   

Accumulated other comprehensive income

     2.3         2.3         2.3   
                          
Total equity      27.5         61.9         102.9   
                          
Total capitalization      61.9         61.9         102.9   
                          

 

(1) In May 2008, we effected a bonus share issuance in the form a share split by issuing an additional approximately 20,800 ordinary shares for each ordinary share outstanding and an additional approximately 20,800 preferred shares for each preferred share outstanding. As a result of the bonus share issuance, the number of outstanding ordinary shares and preferred shares increased to 208,005,986 and 69,994,014, respectively. See “Related Party Transactions—Share Issuances and Splits.” The effect of the bonus share issuance is retroactively reflected for all periods presented herein.

 

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DILUTION

Our net tangible book value as of June 30, 2010 was approximately $26.7 million, or $0.13 per ordinary share as of that date, and $2.34 per ADS. Net tangible book value represents the amount of our total consolidated tangible assets, less the amount of our total consolidated liabilities and our preferred shares. Our pro forma net tangible book value as of June 30, 2010 was approximately $61.1 million, or $0.22 per ordinary share and $3.96 per ADS. Pro forma net tangible book value after giving effect to the conversion of our preferred shares represents our total consolidated tangible assets, less the amount of our total consolidated liabilities. Dilution is determined by subtracting pro forma as adjusted net tangible book value per ordinary share, after giving effect to the conversion of all outstanding preferred shares into ordinary shares immediately upon the completion of this offering and the additional proceeds we will receive from this offering, based on the initial public offering price per ordinary share and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

Without taking into account any other changes in net tangible book value after June 30, 2010, other than to give effect to the conversion of all outstanding preferred shares into ordinary shares immediately upon the completion of this offering and our sale of the ADSs offered in this offering at the initial public offering price of $15.00 per ADS, after deduction of the underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of June 30, 2010 would have been $102.1 million, or $0.30 per outstanding ordinary share and $5.48 per ADS. This represents an immediate increase in pro forma net tangible book value of $0.08 per ordinary share and $1.52 per ADS to our existing shareholders and an immediate dilution in pro forma net tangible book value of $0.53 per ordinary share and $9.52 per ADS to investors purchasing ADSs in this offering. The following table illustrates such dilution:

 

     Per Ordinary Share      Per ADS  

Initial public offering price

   $ 0.83       $ 15.00   

Net tangible book value as of June 30, 2010

   $ 0.13       $ 2.34   

Pro forma net tangible book value after giving effect to the conversion of our preferred shares

   $ 0.22       $ 3.96   

Pro forma as adjusted net tangible book value after giving effect to the conversion of our preferred shares and this offering

   $ 0.30       $ 5.48   

Amount of dilution in pro forma net tangible book value per share to new investors in this offering

   $ 0.53       $ 9.52   

The amount of dilution in pro forma net tangible book value to new investors in this offering set forth above is calculated by deducting (i) the pro forma as adjusted net tangible book value after giving effect to the automatic conversion of our preferred shares and this offering from (ii) the initial public offering price.

 

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The following table summarizes, on a pro forma basis as of June 30, 2010, the differences between our existing shareholders, including holders of our preferred shares that will be automatically converted into ordinary shares immediately upon the completion of this offering, and the new investors with respect to the number of ordinary shares (in the form of ADSs or shares) purchased from us, the total consideration paid and the average price per ordinary share/ADS paid before deducting the underwriting discounts and commissions and estimated offering expenses payable by us.

 

     Ordinary Shares
Purchased
    Total Consideration     Average
Price Per
Ordinary
Share
     Average
Price Per
ADS
 
      Number     %     Amount      %               

Existing shareholders

     278,000,000 (1)      82.8   $ 35,000,000         42.2     0.13         2.27   

New investors

     57,600,000        17.2   $ 48,000,000         57.8     0.83         15.00   
                                      

Total

     335,600,000        100.0   $ 83,000,000         100.0     0.25         4.45   

 

(1) Assumes automatic conversion of all of our preferred shares into ordinary shares upon completion of this offering.

The discussion and tables above also assume no exercise of any outstanding share options. As of September 30, 2010, there were 36,046,200 ordinary shares issuable upon exercise of outstanding share options at a weighted average exercise price of $0.55 per share, and there were 516,158 ordinary shares available for future issuance upon the exercise of future grants under the Plan. To the extent that any of these options are exercised, there will be further dilution to new investors.

 

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EXCHANGE RATES

We conduct substantially all of our operations in China. A substantial portion of our sales are denominated in U.S. dollars, while a significant portion of our costs and expenses are denominated in Renminbi. We make no representation that any Renminbi or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or Renminbi, as the case may be, at any particular rate, at the rates stated below, or at all. The PRC government imposes control over its foreign currency reserves in part through direct regulation of the conversion of Renminbi into foreign exchange and through restrictions on foreign trade. On October 15, 2010, the noon buying rate was RMB6.6905 to $1.00.

The following table sets forth information concerning exchange rates between the Renminbi and the U.S. dollar for the periods indicated. These rates are provided solely for your convenience and are not necessarily the exchange rates that we used in this prospectus or will use in the preparation of our periodic reports or any other information to be provided to you. For all dates and periods through December 31, 2008, exchange rates of Renminbi into the U.S. dollar are based on the noon buying rate in The City of New York for cable transfers of Renminbi as certified for customs purposes by the Federal Reserve Bank of New York. For January 1, 2009 and all later dates and periods, the exchange rate refers to the exchange rate as set forth in the H.10 statistical release of the Federal Reserve Board. Unless otherwise noted, all translations from Renminbi to U.S. dollars and from U.S. dollars to Renminbi in this prospectus were made at a rate of RMB6.8259 to $1.00, the exchange rate set forth in the H.10 statistical release of the Federal Reserve Board on December 31, 2009.

 

     Noon Buying Rate  
Period      Period End           Average(1)          Low          High    
     (RMB per $1.00)  

2006

     7.8041         7.9579         8.0702         7.8041   

2007

     7.2946         7.5806         7.8127         7.2946   

2008

     6.8225         6.9193         7.2946         6.7800   

2009

     6.8259         6.8295         6.8395         6.8180   

2010

           

April

     6.8247         6.8256         6.8275         6.8229   

May

     6.8305         6.8274         6.8310         6.8245   

June

     6.7815         6.8184         6.8323         6.7815   

July

     6.7735         6.7762         6.7807         6.7709   

August

     6.8069         6.7873         6.8069         6.7670   

September

     6.6905         6.7396         6.8102         6.6869   

October (through October 15)

     6.6397         6.6749         6.6912         6.6397   

 

Source: Federal Reserve Statistical Release

(1) Annual averages are calculated using the average of month-end rates of the relevant year. Monthly averages are calculated using the average of the daily rates during the relevant period.

 

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ENFORCEABILITY OF CIVIL LIABILITIES

We were incorporated in the Cayman Islands in order to enjoy certain benefits, such as political and economic stability, an effective judicial system, a favorable tax system, the absence of exchange control or currency restrictions and the availability of professional and support services. However, certain disadvantages accompany incorporation in the Cayman Islands. These disadvantages include a less developed body of Cayman Islands securities laws that provide significantly less protection to investors compared to the laws of the United States, and the potential lack of standing by Cayman Islands companies to sue before the federal courts of the United States.

Our organizational documents do not contain provisions requiring disputes, including those arising under the securities laws of the United States, between us and our officers, directors and shareholders, be arbitrated.

We conduct substantially all of our operations in China, and substantially all of our assets are located in China. Some of our directors and officers are nationals or residents of jurisdictions other than the United States and a substantial portion of their assets are located outside the United States. As a result, it may be difficult for a shareholder to effect service of process within the United States upon us or these persons, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States.

We have appointed Law Debenture Corporate Services Inc. located at 400 Madison Avenue, 4th Floor, New York, New York 10017, as our agent upon whom process may be served in any action brought against us under the securities laws of the United States.

Conyers Dill & Pearman, our counsel as to Cayman Islands law, and Fangda Partners, our counsel as to PRC law, have advised us, respectively, that there is uncertainty as to whether the courts of the Cayman Islands and China, respectively, would:

 

   

recognize or enforce judgments of United States courts obtained against us or our directors or officers predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States; or

 

   

entertain original actions brought in each respective jurisdiction against us or our directors or officers predicated upon the securities laws of the United States or any state in the United States.

Conyers Dill & Pearman has further advised us that the courts of the Cayman Islands would recognize as a valid judgment, a final and conclusive judgment in personam obtained in a federal or state court of the United States under which a sum of money is payable (other than a sum of money payable in respect of multiple damages, taxes or other charges of a like nature or in respect of a fine or other penalty) and would give a judgment based thereon; provided that (a) such courts had proper jurisdiction over the parties subject to such judgment; (b) such courts did not contravene the rules of natural justice of the Cayman Islands; (c) such judgment was not obtained by fraud; (d) the enforcement of the judgment would not be contrary to the public policy of the Cayman Islands; (e) no new admissible evidence relevant to the action is submitted prior to the rendering of the judgment by the courts of the Cayman Islands; and (f) there is due compliance with the correct procedures under the laws of the Cayman Islands.

Fangda Partners has further advised us that the recognition and enforcement of foreign judgments are provided for under the PRC Civil Procedures Law. PRC courts may recognize and enforce foreign judgments in accordance with the requirements of the PRC Civil Procedures Law based either on treaties between China and the country where the judgment is made or on principles of reciprocity between jurisdictions. China does not have any treaties or other form of reciprocity with the United States that provide for the reciprocal recognition and enforcement of foreign judgments. In addition, according to the PRC Civil Procedures Law, courts in the PRC will not enforce a foreign judgment against us or our directors and officers if they decide that the judgment

 

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violates the basic principles of PRC law or national sovereignty, security or public interest. As a result, it is uncertain whether and on what basis a PRC court would enforce a judgment rendered by a court in the United States. Under the PRC Civil Procedures Law, there is no mechanism through which a company established in a foreign jurisdiction could be deemed a PRC resident. Whether a company could be deemed a PRC resident under other regulations, such as tax regulations, does not impact the ability or inability of the shareholders of such company to bring actions against the company under PRC laws. Since the legal connections between our shareholders and our company arise from the laws of jurisdictions other than the PRC, normally it would not be feasible for our shareholders to bring actions against us under PRC laws.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data for the periods and as of the dates indicated should be read in conjunction with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

Our selected consolidated financial data presented below for the years ended December 31, 2007, 2008 and 2009 and our balance sheet data as of December 31, 2008 and 2009 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. Our selected consolidated statement of operations data for the year ended December 31, 2006 and our selected consolidated balance sheet data as of December 2006 and 2007 have been derived from our audited consolidated financial statements not included in this prospectus. Our audited consolidated financial statements are prepared in accordance with U.S. GAAP and have been audited by PricewaterhouseCoopers Zhong Tian CPAs Limited Company, an independent registered public accounting firm. We have not included financial information for the year ended December 31, 2005, as such information is not available on a basis that is consistent with the consolidated financial information for the years ended December 31, 2006, 2007, 2008 and 2009, and cannot be provided on a U.S. GAAP basis without unreasonable effort or expense.

The selected consolidated statement of operations data for the six months ended June 30, 2009 and 2010 and the selected consolidated balance sheet data as of June 30, 2010 have been derived from our unaudited condensed consolidated financial statements included elsewhere in this prospectus and have been prepared on the same basis as our audited consolidated financial statements. The unaudited financial information includes all adjustments, consisting only of normal and recurring adjustments, that we consider necessary for a fair statement of our financial position and operating results for the periods presented. Our historical results do not necessarily indicate results expected for any future periods.

 

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    Year Ended December 31,     Six Months Ended June 30,  
    2006     2007     2008     2009     2009     2010  
    (in millions of $, except for share, per share and per ADS data)  

Consolidated Statements of Operations Data:

           

Net revenues

    17.8        34.7        60.5        72.3        32.7        41.6   

Cost of revenues

    (10.1     (22.8     (40.5     (48.4     (21.8     (27.2
                                               

Gross profit

    7.7        11.9        20.0        23.9        10.9        14.4   
                                               

Operating expenses:

           

Selling and marketing

    (0.3     (0.5     (0.8     (1.7     (0.7     (1.1

General and administrative

    (1.9     (4.0     (9.3     (12.0     (5.6     (6.9
                                               

Total operating expenses

    (2.2     (4.5     (10.1     (13.7     (6.3     (8.0
                                               

Profit from operations

    5.5        7.4        9.9        10.2        4.6        6.4   

Interest income

    *        0.2        0.2        *        *        *   

Interest expense

                                       *   

Other income

    *        0.2        0.9        1.3        0.8        1.6   

Other expenses

    *        (0.1     (1.6     (0.2     (0.1     (0.2
                                               

Income from operations before income taxes

    5.4        7.7        9.4        11.4        5.3        7.8   

Income taxes

    (1.7     (0.2     (0.3     (1.6     (0.7     (0.9
                                               

Net income attributable to ShangPharma Corporation

    3.7        7.5        9.1        9.8        4.6        6.9   

Allocation to preferred shareholders

           (0.7     (2.3     (2.5     (1.2     (1.8
                                               

Net income attributable to ShangPharma Corporation’s ordinary shareholders

    3.7        6.8        6.8        7.3        3.4        5.1   
                                               

Net income attributable to ShangPharma Corporation’s ordinary shareholders per share

           

Basic

    0.02        0.03        0.03        0.04        0.02        0.02   
                                               

Diluted

    0.02        0.03        0.03        0.04        0.02        0.02   
                                               

Net income attributable to ShangPharma Corporation’s ordinary shareholders per ADS(1)

           

Basic

    0.32        0.59        0.59        0.63        0.30        0.44   
                                               

Diluted

    0.32        0.59        0.59        0.63        0.30        0.44   
                                               

Weighted average ordinary shares outstanding(2)

           

Basic

    208,005,986        208,005,986        208,005,986        208,005,986        208,005,986        208,005,986   
                                               

Diluted

    208,005,986        230,381,122        278,000,000        278,051,299        278,000,000        210,362,840   
                                               

Pro forma earnings per share attributable to ShangPharma Corporation’s ordinary shareholders (unaudited)(3)

           

Basic

          0.04          0.02   
                       

Diluted

          0.04          0.02   
                       

Pro forma weighted average ordinary shares outstanding (unaudited)(2) (3) (4)

           

Basic

          278,000,000          278,000,000   
                       

Diluted

          278,051,299          280,356,854   
                       

 

* Less than $50,000.
(1) Each ADS represents 18 ordinary shares.
(2)

In May 2008, we effected a bonus share issuance in the form a share split by issuing an additional approximately 20,800 ordinary shares for each ordinary share outstanding and an additional approximately 20,800 preferred shares for each preferred share outstanding. As a result of the bonus share issuance, the number of outstanding ordinary shares and preferred shares increased to 208,005,986 and

 

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69,994,014, respectively. See “Related Party Transactions—Share Issuances and Splits.” The effect of the bonus share issuance is retroactively reflected for all periods presented herein.

(3) For a description of the pro forma adjustments used to calculate pro forma earnings per share for the year ended December 31, 2009, see “Note 19—Unaudited Pro Forma Balance Sheet and Earnings Per Share for Conversion of Preferred Shares” to our consolidated financial statements included elsewhere in this prospectus.
(4) For a description of the pro forma adjustments used to calculate pro forma earnings per share for the six months ended June 30, 2010, see “Note 15—Unaudited Pro Forma Balance Sheet and Earnings Per Share for Conversion of Preferred Shares” to our unaudited condensed consolidated financial statements included elsewhere in this prospectus.

 

     As of December 31,      As of June 30,  
     2006      2007     2008      2009      2010      2010  
    

(in millions of $)

 
                   (Pro forma)(1)  

Consolidated Balance Sheet Data:

                

Cash

     2.3         19.6        15.8         12.2         10.0         10.0   

Total current assets

     6.0         27.5        28.7         30.1         31.9         31.9   

Total assets

     14.4         45.3        61.7         70.0         78.8         78.8   

Total current liabilities

     6.3         11.5        17.3         15.5         16.9         16.9   

Total liabilities

     6.3         11.5        17.3         15.5         16.9         16.9   

Series A convertible preferred shares

             34.4        34.4         34.4         34.4           

Total equity

     8.1         (0.6     10.0         20.1         27.5         61.9   

Total liabilities and equity

     14.4         45.3        61.7         70.0         78.8         78.8   

 

(1) Pro forma basis reflects the conversion of all outstanding preferred shares on a 1-for-1 basis into an aggregate of 69,994,014 ordinary shares upon the completion of this offering.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the section entitled “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in this prospectus. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this prospectus.

Overview

We are a leading China-based pharmaceutical and biotechnology R&D outsourcing company. We provide a broad range of high-quality, integrated services across the drug discovery and development process to international and Chinese pharmaceutical and biotechnology companies. Capitalizing on our broad service offerings, the experience and expertise of our skilled scientists and our state-of-the-art facilities and equipment, we help our customers discover and develop novel drug candidates efficiently. We have a strong and diversified customer base. We provide services to over 100 customers, including all of the top 10 pharmaceutical and biotechnology companies in the world in terms of 2009 revenues ranked by Frost & Sullivan and a number of fast-growing biotechnology and specialty pharmaceutical companies, as well as renowned academic and research institutions in the U.S. and China. We have experienced significant growth in recent years. The number of our customers increased from 71 in 2007 to 134 in 2009 and 151 in the six months ended June 30, 2010, and our scientific research staff increased from 988 as of December 31, 2007 to 1,525 as of June 30, 2010.

We operate our business as a single segment. Our services consist of discovery chemistry, discovery biology and preclinical development, pharmaceutical development and biologics services. Our core service offering is discovery chemistry, which achieved strong revenue growth from 2007 to 2009. Newer services, such as discovery biology and preclinical development and pharmaceutical development, have grown at a higher rate than discovery chemistry. We began offering biologics services in early 2010. Our integrated service platform allows us to cross-sell additional services to our existing customers. We saw increasing demand from our existing and new customers for integrated services, and a significant majority of our customers hired us for more than one service in each of 2007, 2008 and 2009. We offer our services on an FTE basis or a fee-for-service basis. We derive a significant majority of our net revenues from FTE-based services.

Our net revenues increased from $34.7 million in 2007 to $60.5 million in 2008 and $72.3 million in 2009, representing a CAGR of 44.4%, and increased by 27.2% from $32.7 million in the six months ended June 30, 2009 to $41.6 million in the six months ended June 30, 2010. Such increases were primarily attributable to an increase in the number of customers and resulting projects, broadened service offerings and expanded service capabilities. Our average net revenues per top ten customer increased from $2.9 million in 2007 to $4.7 million in each of 2008 and 2009 and were $2.6 million in the six months ended June 30, 2010. Our net income increased from $7.5 million in 2007 to $9.1 million in 2008 and $9.8 million in 2009, and increased from $4.6 million in the six months ended June 30, 2009 to $6.9 million in the six months ended June 30, 2010.

The global pharmaceutical and biotechnology industry has experienced significant consolidation and, during the global financial crisis, some pharmaceutical and biotechnology companies experienced financial difficulties. As a result, some of our customers reduced their R&D budgets in 2009. We believe our strong growth in net revenues from 2007 to 2009 and from the six months ended June 30, 2009 to the same period ended June 30, 2010 despite industry consolidation and global financial crisis reflected our customers’ recognition of our high-quality, integrated services.

We intend to broaden our service offerings and expand our service capabilities to drive our growth, particularly in research manufacturing and biologics. We are constructing an approximately 460,000 square-foot cGMP-quality multi-purpose manufacturing facility in Fengxian, Shanghai, designed to manufacture advanced

 

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intermediates and APIs for preclinical testing and clinical trials. Phase A of the Fengxian facility, comprising approximately 200,000 square feet, is scheduled to commence operations in early 2011. Phase B of such facility, comprising approximately 260,000 square feet, is estimated to commence operations in 2011 or later. We are also constructing an approximately 150,000 square-foot laboratory services building in Fengxian, Shanghai primarily for pharmaceutical development services. This building is estimated to commence operations in 2011.

In 2008, 2009 and the nine months ended September 30, 2010, our founders granted RSUs convertible to 7,450,000, 2,100,000 and 2,200,000 ordinary shares, respectively, to certain members of our senior management and other employees under the Founder’s Plan. We have not recorded any share-based compensation expense in connection with these RSU grants because one of the vesting conditions for the RSUs is the completion of our initial public offering. As a result, immediately upon completion of this offering, we expect to incur a significant share-based compensation charge of approximately $2.5 million, which will materially and adversely affect our results of operations for the quarter in which this offering is completed.

Factors Affecting Our Results of Operations

We believe the following factors have had, and will continue to have, a significant effect on our results of operations:

Growth of the Global Pharmaceutical and Biotechnology R&D Outsourcing Industry

The growth of the global pharmaceutical and biotechnology R&D outsourcing industry has significantly affected, and is expected to continue to significantly affect, our results of operations. This growth has been primarily driven by the need to contain the cost of drug R&D, accelerate drug R&D process and meet the rising demand from the biotechnology industry. Many large pharmaceutical and biotechnology companies have been “offshoring” and/or outsourcing R&D activities to regions with significant resource and cost advantages, such as China. Advantages offered by China include a large talent pool in the chemistry, biology and medical sciences and related fields, relatively low-cost labor, developed infrastructure and favorable government incentives. The global pharmaceutical and biotechnology industry has experienced significant consolidation and, during the global financial crisis, some pharmaceutical and biotechnology companies experienced financial difficulties. As a result, some of our customers reduced their R&D budgets in 2009. However, the trend in increasing global pharmaceutical and biotechnology R&D outsourcing activities has continued and is expected to continue in the near future. See “Industry.”

Expansion of Our Service Offerings and Capabilities

Expansion and marketing of our service offerings and capabilities are essential to the growth of our business. We believe our customers value our ability to offer a wide range of quality services to meet their drug R&D needs, and we expect to capitalize on our strong customer base and expand our service offerings along the drug discovery and development value chain. Initially focusing on discovery chemistry services, we introduced pharmaceutical development services in 2005 and discovery biology and preclinical development services in 2007. We began offering biologics services in early 2010. We are constructing an approximately 460,000 square-foot cGMP-quality multi-purpose manufacturing facility and an approximately 150,000 square-foot laboratory services building in Fengxian, Shanghai. Our business and results of operations will depend significantly on our ability to expand our service offerings and capabilities as planned and create demand for those newly expanded services or capabilities.

Labor Costs

Labor costs, which constitute a significant component of our cost of revenues, selling and marketing expenses and general and administrative expenses, significantly affect our profitability. Our employee base increased substantially from 1,115 as of December 31, 2007 to 1,755 as of June 30, 2010 and is expected to increase to meet our anticipated growth needs. In addition, our labor costs increased from 2007 to 2009 as we

 

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hired more senior scientists for newer services, such as discovery biology and preclinical development, pharmaceutical development and biologics, as well as more senior management as part of our strategy to grow our business. The increases in labor costs were also attributable to appreciation of the Renminbi relative to the U.S. dollar, as we generally pay our employees in Renminbi, and overall rising labor costs in China. These increases were partially offset by efficiencies gained by our scientists and by our entry into higher margin services. We expect our labor costs as a percentage of total net revenues to decrease or remain relatively stable in the near future as we expect to hire more junior scientists to further expand our R&D team and leverage the experience and expertise of our senior scientists.

Fluctuations in Exchange Rates

Fluctuations in exchange rates affect our cost of revenues and net income and materially impact our operating margins, because our net revenues are primarily generated from sales denominated in U.S. dollars, and a majority of our cost of revenues and operating expenses are denominated in Renminbi. The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in China’s political and economic conditions. The conversion of Renminbi into foreign currencies, including the U.S. dollar, has been based on rates set by the People’s Bank of China. On July 21, 2005, the PRC government changed its policy of pegging the value of the Renminbi to the U.S. dollar and began allowing modest appreciation of the Renminbi versus the U.S. dollar. This change in policy has resulted in an appreciation of approximately 22.0% of the Renminbi against the U.S. dollar from July 21, 2005 to June 30, 2010. The PRC government faces significant international pressure to further liberalize its currency policy, which could result in further appreciation in the value of the Renminbi against the U.S. dollar. Any further appreciation in the value of the Renminbi against the U.S. dollar will increase our cost of revenues and operating expenses and, if not passed on to our customers in the form of higher prices, adversely affect on our margins.

Selected Statements of Operations Items

Net Revenues

Our net revenues comprise our total revenues from operations, less sales taxes. We offer our laboratory services on an FTE basis or a fee-for-service basis. An FTE arrangement differs from fee-for-service arrangements in that generally a team of our scientists is assigned to the needs of an individual customer for a particular period. The customer pays a fixed rate per FTE regardless of the workload or changes in the assignment, as determined in each contract, and the price generally includes some of the material costs incurred. Fees from FTE services are generally not contingent on outcomes or other deliverables or milestones. Revenues from fee-for-service contracts are typically contingent on successful performance of a service or delivery of a product and the price is often fixed in the contract. Fee-for-service contracts have different terms but are generally shorter in duration than FTE contracts. Revenues from these contracts fluctuate from period to period depending on, among other things, the nature of services and the completion schedule.

The increases in our net revenues from 2007 to 2009 and from the six months ended June 30, 2009 to the same period ended June 30, 2010 were attributable primarily to a larger customer base and a broader scope of services we provided to our customers. We began providing pharmaceutical development services in 2005 and discovery biology and preclinical development services in 2007. We introduced biologics services in early 2010. We derive a significant majority of our revenues from FTE contracts. The following table sets forth our FTE-based net revenues and fee-for-service-based net revenues by amount and as a percentage of our total net revenues for the periods indicated:

 

    Year Ended December 31,     Six Months Ended June 30,  
    2007     2008     2009     2009     2010  
    Net
Revenues
        Net
Revenues
    %     Net
Revenues
    %     Net
Revenues
    %     Net
Revenues
    %  
    (in millions of $, except for percentages)  

FTE-based net revenues

    29.9        86.0     47.8        79.1     56.7        78.4     26.5        81.2     30.9        74.4

Fee-for-service-based net revenues

    4.8        14.0        12.7        20.9        15.6        21.6        6.2        18.8        10.7        25.6   
                                                                               

Total net revenues

    34.7        100.0     60.5        100.0     72.3        100.0     32.7        100.0     41.6        100.0
                                                                               

 

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We derive FTE-based revenues primarily from our discovery chemistry services. FTE-based revenues as a percentage of our total net revenues decreased from 86.0% in 2007 to 78.4% in 2009 and 74.4% in the six months ended June 30, 2010 as we expanded our newer service offerings, such as discovery biology and preclinical development and pharmaceutical development, which are more typically covered by fee-for-service contracts.

We generated a significant majority of our net revenues in 2007, 2008, 2009 and the six months ended June 30, 2010 from U.S.-based customers, with most of the remaining revenues from customers based in Europe, Japan and China. A majority of our net revenues came from pharmaceutical companies, while biotechnology and specialty pharmaceutical customers contributed to a significant portion of our net revenues during the same periods.

Cost of Revenues

Cost of revenues consists primarily of (i) labor costs, including salaries, bonuses and other benefits, for employees who provide laboratory services, (ii) raw material costs, including catalysts, reagents, solvents and other laboratory supplies and (iii) overhead costs, which primarily include the depreciation of equipment, property improvement and operating lease expenses for our leased facilities.

Labor is a significant component of our cost of revenues and therefore an important factor affecting our profitability. Our headcount increased substantially from 2007 to the six months ended June 30, 2010 as we expanded our service offerings and is expected to continue increasing to meet our anticipated growth needs. Our labor costs as a percentage of total net revenues increased slightly from 2007 to 2009 and from the six months ended June 30, 2009 to the same period ended June 30, 2010 due to our hiring of more senior scientists for our newer services, appreciation of the Renminbi relative to the U.S. dollar and overall rising labor costs in China. Such increase was partially offset by efficiencies gained by our scientists and by our entry into higher margin services.

Our raw material costs as a percentage of our total net revenues decreased from 2007 to 2009 and from the six months ended June 30, 2009 to the same period ended June 30, 2010 due to our tighter cost control measures, such as improving raw material usage efficiencies, as well as our increased bargaining power resulting from economies of scale.

Our overhead costs increased from 2007 to 2009 and from the six months ended June 30, 2009 to the same period ended June 30, 2010 as we expanded our facilities and purchased new equipment. We expect our overhead costs to increase as a result of depreciation of our manufacturing facility and laboratory services building in Fengxian, Shanghai upon its completion.

Cost of revenues also includes an allocation of our share-based compensation charges. See “—Critical Accounting Policies—Share-Based Compensation Expenses.”

Gross Profit and Margin

Gross profit is equal to net revenues less cost of revenues. Gross margin is equal to gross profit divided by net revenues. Changes in our gross profit and margin from period to period are primarily driven by our service mix and net revenue per FTE as well as exchange rate fluctuations. Our gross margin was 34.2% in 2007, 33.0% in 2008, 33.0% in 2009 and 33.3% and 34.5% in the six months ended June 30, 2009 and 2010. Our gross margin was negatively impacted by the appreciation of the Renminbi relative to the U.S. dollar during these periods. Appreciation of the Renminbi, the currency in which we incur most of our expenses, in relation to the U.S. dollar, the currency in which we earn most of our revenues, puts pressure on our gross margin. Our gross margin was also negatively impacted by our increased labor costs and, from 2007 to 2009, by increased depreciation expenses related to our expanded facilities and equipment. These adverse effects were partially offset by our

 

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improved cost control measures, growth in higher margin service offerings, increases in net revenue per FTE, economies of scale and improvements in operational efficiency.

Operating Expenses

Our operating expenses consist of selling and marketing expenses and general and administrative expenses.

Selling and Marketing Expenses. Selling and marketing expenses consist primarily of salaries, bonuses, commissions and other benefits of our sales and business development personnel and promotional activities and tradeshow expenses. Our selling and marketing expenses increased from 2007 to 2009 and from the six months ended June 30, 2009 to the same period ended June 30, 2010 primarily because we built sales and marketing teams in the U.S. and Europe during these periods. We expect that selling and marketing expenses will grow as a result of our efforts to increase market presence and drive revenue growth.

General and Administrative Expenses. General and administrative expenses consist primarily of (i) salaries, bonuses and other benefits for management and employees in our administration departments including finance, human resources, executive office, legal and information technology departments, (ii) depreciation and amortization of non-laboratory property, equipment and software and (iii) professional service fees.

Our general and administrative expenses increased from 2007 to 2009 and from the six months ended June 30, 2009 to the same period ended June 30, 2010 as our business expanded, including the hiring of additional executives and management staff. We expect our general and administrative expenses to increase in future periods as our business grows and we incur increased costs related to complying with our reporting obligations under the U.S. securities laws as a public company. In addition, upon completion of this offering, we expect to incur a significant share-based compensation charge in connection with the vesting of granted RSUs. See “—Critical Accounting Policies—Share-Based Compensation Expenses—Founder’s 2008 Equity and Performance Incentive Plan.”

Our operating expenses include an allocation of our share-based compensation charges. See “—Critical Accounting Policies—Share-Based Compensation Expenses.”

Income Taxes

Cayman Islands

We are incorporated in the Cayman Islands. Under the current laws of the Cayman Islands, we are not subject to income or capital gains tax. In addition, dividend payments are not subject to withholding tax in the Cayman Islands.

Hong Kong

Our subsidiaries did not have assessable profits that were earned in or derived from Hong Kong during the years ended December 31, 2007, 2008 and 2009 and the six months ended June 30, 2010. Accordingly, we did not pay Hong Kong profits tax during these periods.

PRC

Prior to the effectiveness of the PRC Enterprise Income Tax Law on January 1, 2008, enterprises in China were generally subject to an enterprise income tax at a statutory rate of 33% unless they qualified for certain preferential treatment. Starting January 1, 2008, the PRC Enterprise Income Tax Law has imposed a

 

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uniform enterprise income tax rate of 25% on all domestic enterprises and foreign-invested enterprises unless they qualify for certain exceptions. Enterprises established before March 16, 2007 that were entitled to the then available preferential tax treatment may continue to enjoy such treatment (i) in the case of preferential tax rates, for a maximum of a five-year period starting from January 1, 2008; during such period, the tax rate will gradually increase to 25%, or (ii) in the case of preferential tax exemption or reduction for a specified term, until the expiration of such term.

Shanghai ChemExplorer Co., Ltd. was entitled to a one-year exemption from enterprise income tax for year 2007, and a 50% reduction on the otherwise applicable enterprise income tax rate for the subsequent three years, and Shanghai PharmaExplorer Co., Ltd. and Shanghai ChemPartner Co., Ltd. are entitled to a two-year exemption from enterprise income tax for 2007 and 2008, and a 50% reduction on the otherwise applicable enterprise income tax rate for the subsequent three years. Accordingly, the enterprise income tax rate applicable to Shanghai ChemExplorer Co., Ltd. will gradually increase from 9% to 11% from 2008 to 2010. The enterprise income tax rate applicable to Shanghai PharmaExplorer Co., Ltd. and Shanghai ChemPartner Co., Ltd. will gradually increase from 10% to 12% from 2009 to 2011. In addition, Shanghai ChemExplorer Co., Ltd. and Shanghai ChemPartner Co., Ltd. have been approved as high and new technology enterprises since 2008 and are entitled to a preferential tax rate of 15%. Chengdu Chempartner Co., Ltd. is located in Chengdu, China and was recognized as a high and new technology enterprise in 2008 and will be entitled to an enterprise income tax rate of 15% if it generates taxable income and continues to qualify as a high and new technology enterprise. The high and new technology enterprise status is subject to approval and renewal every three years.

Prior to 2006, we recorded a majority of our income in our offshore entities, which are exempted from China’s enterprise income tax. In 2007, we concluded that this treatment no longer corresponds to our operations. We subsequently revised the manner in which we record our income. We voluntarily disclosed the revision with the local tax authorities and agreed to pay a total of $2.0 million to the tax authorities in April 2008, which consisted of income tax expense of $1.7 million and a late filing interest charge of $0.3 million. We recorded the $1.7 million as income tax expenses in 2006 and the late interest charge of $0.2 million and $0.1 million for 2007 and 2008 as income tax expenses in 2007 and 2008, respectively.

Our effective enterprise tax rate was 2% for 2007, 3% for 2008, 14% for 2009, and 14% and 12% for the six months ended June 30, 2009 and 2010, respectively. See “Note 11—Taxation” to our consolidated financial statements included elsewhere in this prospectus.

Critical Accounting Policies

We prepare our financial statements in conformity with U.S. GAAP, which requires us to make estimates and assumptions that affect our reporting of, among other things, assets and liabilities, contingent assets and liabilities and net revenues and expenses. We regularly evaluate these estimates and assumptions based on the most recently available information, our historical experience and other factors that we believe to be relevant under the circumstances. Since our financial reporting process inherently relies on the use of estimates and assumptions, our actual results could differ from what we expect. This is especially true with some accounting policies that require higher degrees of judgment than others in their application. We consider the policies discussed below to be critical to an understanding of our audited consolidated financial statements because they involve the greatest reliance on our management’s judgment.

Revenue Recognition

Revenues are recognized when persuasive evidence of an arrangement exists, the sales price is fixed or determinable, delivery of the product or performance of the service has occurred and there is reasonable assurance of collection of the sales proceeds.

 

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For laboratory services provided on an FTE basis, the customer pays a fixed rate per laboratory worker on a full time employment basis and we recognize revenue as the services are provided. There is no requirement for fixed deliverables by us or acceptance by our customers under the FTE contracts.

For laboratory services provided on a fee-for-service with one or multiple elements of deliverables, we recognize revenue as each element is earned, provided that the fair value of the undelivered element(s) has been determined, the delivered element(s) has stand-alone value, there is no right of return on delivered element(s) and we are in control of the undelivered element(s). An element is considered earned upon the delivery and acceptance of the deliverables. For arrangements that include service elements, revenue is recognized for the service element using the proportionate performance method.

Under certain arrangements, a customer pays us a bonus if we achieve certain milestones. Such bonus payment is recognized as revenue upon the achievement of the milestones.

Costs incurred prior to the delivery and acceptance of the deliverables are capitalized in inventory as work in progress. Cash received in advance of the delivery and acceptance of the deliverables is recorded as an advance from customers.

Revenues from the sale of manufactured products are recognized upon delivery and acceptance by the customer after title and risk of loss have been transferred.

Impairment of Long-Lived Assets

We review long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparing their carrying amounts to the future undiscounted cash flows the assets are expected to generate. If the sum of the expected undiscounted cash flow is less than the carrying amount of the assets, we recognize an impairment loss equal to the amount by which the carrying value of the asset exceeds its fair value. We need to make judgments and estimates on expected cash flow and discount rates to derive fair value. No impairment of long-lived assets was recognized for the years ended December 31, 2007, 2008 and 2009 and the six months ended June 30, 2010.

Accounts Receivable

Accounts receivable are presented net of allowance for doubtful accounts. We provide specific allowance for doubtful accounts when facts and circumstances indicate that the collection is doubtful and a loss is probable and estimable. For the years ended December 31, 2007, 2008 and 2009, we recorded allowances for doubtful accounts of nil, $83,435 and $30,000, respectively, and did not write off any doubtful accounts for these periods. For the six months ended June 30, 2009 and 2010, we recorded allowances for doubtful accounts of $30,000 and $34,058, respectively, and wrote off doubtful accounts of nil and $83,435, respectively. Allowance for doubtful accounts was $113,435 as of December 31, 2009 and $64,058 as of June 30, 2010.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred taxes are determined based upon differences between the financial reporting and tax bases of assets and liabilities at currently enacted statutory tax rates for the years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in the consolidated statements of operations in the period of change. A valuation allowance is provided on deferred tax assets to the extent that it is more likely than not that such deferred tax assets will not be realized. In assessing whether such deferred tax assets can be realized in the future, we need to make judgments and estimates on the ability to generate taxable income in future years. The total income tax provision includes current tax expenses under applicable tax regulations and the change in the balance of deferred tax assets and liabilities. We follow the guidance on accounting for uncertain tax positions in income taxes to recognize and measure our uncertain tax positions.

 

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Share-Based Compensation Expenses

2008 Equity and Performance Incentive Plan

On May 19, 2008, we adopted the Plan to attract and retain the best available personnel and provide additional incentives to employees, directors and consultants. On February 24, 2010, we amended and restated the Plan to increase the maximum aggregate number of our shares that may be issued under the Plan to 36,562,358 shares. As of September 30, 2010, options to purchase 36,046,200 ordinary shares were outstanding. The following table sets forth the options granted since the adoption of the Plan that were outstanding as of September 30, 2010:

 

Date of Grant

   Options
Outstanding
     Exercise
Price
     Fair Value of
Ordinary Shares
     Weighted-
Average Fair
Value of Options
     Intrinsic Value  
            ($)      ($)      ($)      ($)  

May 19, 2008

     11,296,000         0.50         0.20         0.04           

October 27, 2008

     6,177,050         0.50         0.21         0.04           

May 13, 2009

     3,679,700         0.50         0.45         0.20           

October 14, 2009

     3,815,700         0.50         0.55         0.27         0.05   

May 24, 2010

     3,695,650         0.65         0.65         0.30        

  

July 30, 2010

     7,382,100         0.65         0.69         0.33         0.04   

Share-based compensation expense for all share-based awards granted to employees is determined based on the grant date fair value. Share-based compensation is expensed ratably on a straight-line basis for awards with vesting schedules based on service conditions only over the requisite service period, which is generally the vesting term of the share-based awards. A graded vesting method is applied to awards with vesting schedules with performance conditions.

Certain recipients of our share options became our consultants after their respective grant dates. We account for equity instruments issued to external consultants under the fair value method. The measurement date of the fair value of an equity instrument issued is the date on which the consultant’s performance is completed. Prior to the measurement date, the equity instrument is measured at its then-current fair value at each of the reporting dates. Share-based expense will be recognized over the service period using the graded-vesting method, and will be adjusted to reflect changes in the fair value of our ordinary shares between the reporting periods up to the measurement date.

We engaged Jones Lang LaSalle Sallmanns Limited, or Sallmanns, an independent third party appraiser, to assess the fair value of our share options and the ordinary shares underlying the options. We and Sallmanns estimated share-based compensation expense for share options on the grant date based on each option’s fair value as calculated using the Black-Scholes option pricing model and the assumptions set forth in the following table:

 

     For the Year Ended December 31,      For the Seven Months
Ended July 31,

2010
 
             2008                      2009             

Risk-free interest rate(1)

     4.42-5.34%         3-3.72%         2.75-3.37%   

Expected life (in years)(2)

     5-7 years         5-7 years         5-7 years   

Expected dividend yield(3)

     0%         0%         0%   

Expected volatility(4)

     33-39%         42-43%         41-44%   

Fair value per option at grant date

     $0.02-0.05         $0.18-0.28         $0.28-0.35   

 

(1) The risk-free interest rate for the contractual term of the share option is based on the yield of China government bonds denominated in U.S. dollars in effect at the time of grant for a term consistent with the expected term of the awards.
(2) The expected life of the share options granted under the Plan is based on vesting period, contractual term, share price, the employee’s level within our company and the expected volatility of the underlying shares.
(3) We do not expect to pay dividends on our ordinary shares during the term of the options.
(4) Expected volatility is estimated based on the historical volatilities of the comparable companies in a similar industry as of the valuation dates.

 

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As a private company with no quoted market for our ordinary shares, we need to estimate the fair value of our ordinary shares at the relevant grant dates. In determining the fair values of our ordinary shares as of each award grant date, Sallmanns considered three generally accepted valuation approaches: market, cost and income. The market approach requires market transactions of comparable assets as an indication of value. However, current comparable market transactions were not identified. The cost approach considers the cost to reproduce or replace the subject assets for similar assets at current market prices. While useful for certain purposes, the cost approach is generally considered not applicable to the valuation of a company as a going concern, as it does not capture the future earning potential of the business. In view of the above, Sallmanns determined that the income approach is the most appropriate method to derive the fair values of our ordinary shares.

The income approach involved applying appropriate discount rates to projected cash flows using management’s best estimates as of the valuation dates. The projected cash flows reflected, among other things, an analysis of projected revenue growth, profit margins, effective tax rates, capital expenditures and terminal multiples. The major assumptions used in determining the equity value of our company were consistent with our business plan and major milestones that we achieved. Other major assumptions used in determining the equity value of our company included the following:

 

   

weighted average costs of capital of 13.6%, 13.9%, 14.4%, 13.6%, 14.9% and 15.0% were used on May 19, 2008, October 27, 2008, May 13, 2009, October 14, 2009, May 24, 2010 and July 30, 2010, respectively. They were the combined results of changes in the risk-free rate, equity risk premium, industry average beta, country premium and size premium; and

 

   

discounts for lack of marketability of 17.6%, 17.6%, 17.6%, 17.6%, 7.5% and 8.0% were used on May 19, 2008, October 27, 2008, May 13, 2009, October 14, 2009, May 24, 2010 and July 30, 2010, respectively, to reflect that, as of these grant dates, we were a closely-held company and there was no public market for our ordinary shares. This took into consideration our proposed initial public offering in the near future.

We and Sallmanns also used other general inherently uncertain but best available assumptions, including the following: no material changes in the existing political, legal, fiscal and economic conditions and the CRO industry in China; no significant contingent liabilities, unusual contractual obligations or substantial commitments; our ability to retain competent management and key personnel to support our ongoing operations; and no material deviation in market conditions from economic forecasts.

The valuation model then allocated the equity value between our ordinary shares and our preferred shares. The fair value of the equity interest allocated to the preferred shares was calculated using the option pricing method. Under the option pricing method, the preferred shares were treated as a call option on our equity value, with the exercise price based on the liquidation preference of the preferred shares. Because a call option was used, the option pricing method commonly used is the Black-Scholes model, which takes into account the expected life of the option, a risk-free interest rate, dividend yield and volatility. Because we are a private company, Sallmanns approximated volatility using the historical volatility of selected comparable publicly traded CROs listed in the U.S. In selecting such comparable companies, Sallmanns considered factors including the nature of business, product offerings in the drug R&D process, target markets and customers, financial performance and stage of development.

Based on the foregoing analysis and valuation performed by Sallmanns, we concluded that the fair value of our ordinary shares was $0.20, $0.21, $0.45, $0.55, $0.65 and $0.69 per share as of May 19, 2008, October 27, 2008, May 13, 2009, October 14, 2009, May 24, 2010 and July 30, 2010, respectively.

The fair value of our ordinary shares only increased slightly from May 19, 2008 to October 27, 2008 because there were no significant developments in our business or changes in cash flow projections or other assumptions during this period.

 

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The increase in the fair value of our ordinary shares from October 27, 2008 to May 13, 2009 was primarily attributable to the following developments during such period:

 

   

in response to the global financial crisis and economic downturn, we strengthened our measures to control costs and capital expenditures and improved operational efficiency, which were expected to sustain our gross and net profit margins for the following few years. For example, we established a monitoring and control system to achieve efficient staffing, improve procurement efficiency and maximize utilization of equipment;

 

   

we changed the construction schedule of Phase B of the manufacturing facility in Fengxian, Shanghai, so that we would start the construction of Phase B after Phase A achieves a satisfactory utilization rate (instead of shortly after Phase A commences operation), which was expected to reduce our capital expenditures in the near term; and

 

   

the Renminbi had appreciated at a slower pace, or approximately 0.4% from October 2008 to May 2009, and was expected to continue appreciating at a relatively slow pace, which benefited our results of operations.

The increase in the fair value of our ordinary shares from May 13, 2009 to October 14, 2009 was primarily attributable to the following developments during such period:

 

   

we strengthened our measures to control costs and capital expenditures and improved operational efficiency, which were expected to sustain our gross and net profit margins for the following few years; and

 

   

a decrease in weighted average costs of capital from 14.4% to 13.6% as a result of relevant capital market developments, including changes in the risk-free rate, equity risk premium and size premium.

The increase in the fair value of our ordinary shares from October 14, 2009 to May 24, 2010 was primarily attributable to the following developments during such period:

 

   

a decrease in the discount for lack of marketability from 17.6% to 7.5% as we prepared for our initial public offering in the first half of 2010;

 

   

we experienced increases in net revenues and net income from $19.8 million and $2.5 million, respectively, in the fourth quarter of 2009 to $21.8 million and $4.1 million, respectively, in the second quarter of 2010; and

 

   

our gross margin increased from 32.6% in the fourth quarter of 2009 to 33.9% in the second quarter of 2010, due in part to our measures to control costs and capital expenditures and our improved operational efficiency.

The increase in the fair value of our ordinary shares from May 24, 2010 to July 30, 2010 was primarily attributable to the increased probability that we would undertake our proposed initial public offering.

We have considered the guidance prescribed by the American Institute of Certified Public Accountants (AICPA) Audit and Accounting Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, or the Practice Aid, in determining the fair value of our ordinary shares as of various dates before this offering. A detailed description of the valuation method used and the factors contributing to the changes in the fair value of our ordinary shares through July 30, 2010 is set out above. Paragraph 113 of the Practice Aid states that “the ultimate IPO price itself also is generally not likely to be a reasonable estimate of the fair value for pre-IPO equity transactions of the enterprise.” We therefore believe the ultimate price of this offering is generally not likely to be a reasonable estimate of the fair value of our ordinary shares as of various dates before this offering.

 

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Nevertheless, we believe that the implied increase in fair value of our ordinary shares from $0.69 per share as of July 30, 2010 to the initial public offering price (after adjusting for the ADS to ordinary share ratio), is primarily attributable to the following factors:

 

   

The impending launch of this offering is expected to provide us with additional capital, enhance our ability to access capital markets and raise our profile; and

 

   

The completion of this offering is expected to result in increased liquidity and marketability of our ordinary shares.

Our share-based compensation expense related to the options granted by us under the Plan amounted to $68,752 in 2008, $251,950 in 2009 and $353,370 in the six months ended June 30, 2010. Determining the value of our share-based compensation expenses requires the input of highly subjective assumptions, including the expected life of the share-based awards, estimated forfeitures and the price volatility of the underlying shares. The assumptions used in calculating the fair value of share-based awards represent our best estimates, but these estimates involve inherent uncertainties and the application of our judgment. As a result, if factors change and we use different assumptions, our share-based compensation expenses could be materially different in the future.

Founder’s 2008 Equity and Performance Incentive Plan

In May 2008, our founders and our company established the Founder’s Plan to attract, motivate and retain our employees, non-employee directors and consultants. See “Management—Founder’s 2008 Equity and Performance Incentive Plan” for a summary of the key terms of the Founder’s Plan.

In 2008, 2009 and the nine months ended September 30, 2010, our founders granted RSUs convertible to 7,450,000, 2,100,000 and 2,200,000 ordinary shares, respectively, to certain members of our senior management and other employees under the Founder’s Plan. We estimated the share-based compensation expense for RSUs granted under the Founder’s Plan based on the fair value of the RSUs on the date of grant. We have not recorded any share-based compensation expense in connection with these RSU grants because one of the vesting conditions for the RSUs is the completion of our initial public offering. As a result, immediately upon completion of this offering, we expect to incur a significant share-based compensation charge of approximately $2.5 million, which will materially and adversely affect our results of operations for the quarter in which this offering is completed.

Internal Control over Financial Reporting

In preparing our consolidated financial statements, we and our independent registered public accounting firm identified one material weakness and other deficiencies in our internal control over financial reporting as of December 31, 2009. As defined in standards established by the PCAOB, a “material weakness” is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.

The material weakness identified related to a lack of sufficient competent personnel with appropriate levels of accounting knowledge and experience to perform period end reporting procedures, address complex U.S. GAAP accounting issues and prepare and review financial statements and related disclosures under U.S. GAAP. Neither we nor our independent registered public accounting firm undertook a comprehensive assessment of our internal control for purposes of identifying and reporting material weaknesses and other control deficiencies in our internal control over financial reporting, as we and they will be required to do once we become a public company. Had we performed a formal assessment of our internal control over financial reporting or had our independent registered public accounting firm performed an audit of our internal control over financial reporting, additional control deficiencies may have been identified.

 

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Following the identification of this material weakness and other control deficiencies and in connection with preparation of our consolidated financial statements, we performed additional review procedures, including a thorough review of journal entries and reconciliations for key accounts, to ensure the completeness and accuracy of the consolidated financial statements prepared in accordance with U.S. GAAP.

To remedy our control deficiencies, we have adopted several measures to improve our internal control over financial reporting. We recently hired additional finance and accounting personnel, including a finance controller and a finance manager with U.S. GAAP and SEC reporting experience. In addition, we have (i) provided, and intend to continue to provide, on-going training to our accounting and operating personnel across different subsidiaries and departments to improve their U.S. GAAP accounting knowledge; (ii) established and strengthened our IT systems and controls related to the IT systems to ensure proper record keeping; (iii) developed comprehensive quarterly closing procedures that require certain documentation and records to be completed and reviewed; (iv) updated and improved our accounting manual; (v) hired an internal audit director with prior experience at a China-based company listed in the United States; and (vi) engaged an outside consultant to assist us in preparing for compliance with Section 404 of the Sarbanes-Oxley Act. We are also in the process of, among other things, evaluating our financial accounting system for adequacy and potential upgrades. We will continue to implement measures to remedy our internal control deficiencies in order to meet the deadline imposed by Section 404 of the Sarbanes-Oxley Act. However, the implementation of these measures may not fully address the deficiencies in our internal control over financial reporting. We are not able to estimate with reasonable certainty the costs that we will need to incur to implement these and other measures designed to improve our internal control over financial reporting. See “Risk Factors—Risks Related to Our Business and Industry—In preparing our consolidated financial statements, we have identified one material weakness and other deficiencies in our internal control over financial reporting. If we fail to develop and maintain an effective system of internal control over financial reporting, we may be unable to accurately report our financial results or prevent fraud, and investor confidence in our company and the market price of our ADSs may be adversely affected.”

 

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Results of Operations

The following table sets forth a summary of our consolidated results of operations by amount and as a percentage of our total net revenues for the periods indicated. This information should be read together with our consolidated financial statements and related notes included elsewhere in this prospectus. The operating results in any period are not necessarily indicative of the results that may be expected for any future period.

 

    Year Ended December 31,     Six Months Ended June 30,  
    2007     2008     2009     2009     2010  
    Net
Revenues
    %     Net
Revenues
    %     Net
Revenues
    %     Net
Revenues
    %     Net
Revenues
    %  
    (in millions of $, except for percentages)  

Net revenues

    34.7        100.0     60.5        100.0     72.3        100.0     32.7        100.0     41.6        100.0

Cost of revenues

    (22.8     (65.8     (40.5     (67.0     (48.4     (67.0     (21.8     (66.7     (27.2     (65.5
                                                                               

Gross profit

    11.9        34.2        20.0        33.0        23.9        33.0        10.9        33.3        14.4        34.5   
                                                                               

Operating expenses:

                   

Selling and marketing

    (0.5     (1.5     (0.8     (1.4     (1.7     (2.2     (0.7     (1.9     (1.1     (2.6

General and administrative

    (4.0     (11.5     (9.3     (15.3     (12.0     (16.6     (5.6     (17.3     (6.9     (16.6
                                                                               

Total operating expenses

    (4.5     (13.0     (10.1     (16.7     (13.7     (18.8     (6.3     (19.2     (8.0     (19.2
                                                                               

Profit from operations

    7.4        21.2        9.9        16.3        10.2        14.2        4.6        14.1        6.4        15.3   

Interest income

    0.2        0.6        0.2        0.4        *        **        *        **        *        **   

Interest expense

                                                            *        **   

Other income

    0.2        0.6        0.9        1.5        1.3        1.8        0.8        2.5        1.6        3.9   

Other expenses

    (0.1     (0.3     (1.6     (2.7     (0.2     (0.3     (0.1     (0.3     (0.2     (0.4
                                                                               

Income from operations before income taxes

    7.7        22.1        9.4        15.5        11.4        15.7        5.3        16.3        7.8        18.8   

Income taxes

    (0.2     (0.5     (0.3     (0.5     (1.6     (2.1     (0.7     (2.3     (0.9     (2.3
                                                                               

Net income

    7.5        21.6     9.1        15.0     9.8        13.6     4.6        14.0     6.9        16.5
                                                                               

 

* Less than $50,000.
** Less than 0.1%.

Six Months Ended June 30, 2010 Compared to Six Months Ended June 30, 2009

Net Revenues

Our net revenues increased by 27.2% from $32.7 million in the six months ended June 30, 2009 to $41.6 million in the six months ended June 30, 2010, primarily due to an increase in the number of customers and our expanded scope of services. We provided services to 151 customers in the six months ended June 30, 2010 compared to 88 customers in the same period ended June 30, 2009. The following table sets forth our FTE-based net revenues and fee-for-service-based net revenues by amount and as a percentage of our total net revenues for the periods indicated:

 

     Six Months Ended June 30,  
     2009     2010  
     Net
Revenues
     %     Net
Revenues
     %  
     (in millions of $, except for percentages)  

FTE-based net revenues

     26.5         81.2     30.9         74.4

Fee-for-service-based net revenues

     6.2         18.8        10.7         25.6   
                                  

Total net revenues

     32.7         100.0     41.6         100.0
                                  

 

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Net revenues from FTE-based services increased by 16.3% from $26.5 million in the six months ended June 30, 2009 to $30.9 million in the six months ended June 30, 2010, due to increases in the average number of FTEs and net revenue per FTE. Net revenues from our fee-for-service-based services increased by 74.7% from $6.2 million in the six months ended June 30, 2009 to $10.7 million in the six months ended June 30, 2010. The increase in demand for our FTE-based and fee-for-service-based services was primarily due to an increase in demand for our pharmaceutical development, discovery biology and preclinical development and discovery chemistry services. FTE-based revenues as a percentage of our total net revenues decreased from 81.2% in the six months ended June 30, 2009 to 74.4% in the six months ended June 30, 2010 as we expanded our newer services offerings, such as discovery biology and preclinical development and pharmaceutical development, which are more typically covered by fee-for-service contracts.

Cost of Revenues

Our cost of revenues increased by 24.9% from $21.8 million in the six months ended June 30, 2009 to $27.2 million in the six months ended June 30, 2010. The increase in our cost of revenues was primarily due to increases in labor, raw materials and overhead costs. The increase in our labor costs was primarily due to higher headcount and the hiring of more senior scientists for our newer services, such as biologics, as well as overall rising labor costs in China. Such increase was partially offset by efficiencies gained by our scientists and by our entry into higher margin services. Our raw material costs as a percentage of our total net revenues decreased from the six months ended June 30, 2009 to the same period ended June 30, 2010 due to our cost control measures, such as improving raw materials usage efficiencies, as well as our increased bargaining power resulting from economies of scale. Our overhead costs increased as we expanded our facilities and purchased new equipment.

Gross Profit and Margin

Our gross profit increased by 31.9% from $10.9 million in the six months ended June 30, 2009 to $14.3 million in the six months ended June 30, 2010, primarily due to the increase in our net revenues. Our gross margin increased from 33.3% in the six months ended June 30, 2009 to 34.5% in the six months ended June 30, 2010, mainly attributable to our improved cost control measures, growth in higher margin services, economies of scale and improvements in operational efficiency. Such increase was partially offset by increased labor costs, particularly those of newly hired senior scientists for our newer services still in development.

Operating Expenses

Our total operating expenses increased by 27.2% from $6.3 million in the six months ended June 30, 2009 to $8.0 million in the six months ended June 30, 2010.

Selling and Marketing Expenses. Our selling and marketing expenses increased by 71.4% from $0.7 million in the six months ended June 30, 2009 to $1.1 million in the six months ended June 30, 2010. The increase in selling and marketing expenses was primarily due to our hiring of new sales and business development personnel in the U.S. and Europe in the second half of 2009 and the first half of 2010 to increase market penetration and demand for our services in those regions.

General and Administrative Expenses. Our general and administrative expenses increased by 22.3% from $5.6 million in the six months ended June 30, 2009 to $6.9 million in the six months ended June 30, 2010, primarily due to an increase in the headcount of our senior management and administrative employees.

Other Income

Our other income increased from $0.8 million in the six months ended June 30, 2009 to $1.6 million in the six months ended June 30, 2010, primarily due to a gain of $1.0 million on foreign exchange forward

 

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contracts in the six months ended June 30, 2010, compared to a gain of $0.1 million on such contracts in the six months ended June 30, 2009.

Income Tax Expense

Our income tax expense increased from $0.7 million in the six months ended June 30, 2009 to $0.9 million in the six months ended June 30, 2010, reflecting an increase in income before tax, partially offset by a decrease in our effective tax rate from 14% to 12%.

Net Income

As a result of the foregoing, our net income increased from $4.6 million in the six months ended June 30, 2009 to $6.9 million in the six months ended June 30, 2010.

Year Ended December 31, 2009 Compared to Year Ended 31, December 2008

Net Revenues

Our net revenues increased by 19.5% from $60.5 million in 2008 to $72.3 million in 2009, primarily due to an increase in the number of customers and our expanded scope of services. We provided services to 134 customers in 2009 compared to 99 customers in 2008. The following table sets forth our FTE-based net revenues and fee-for-service-based net revenues by amount and as a percentage of our total net revenues for the periods indicated:

 

     Year Ended December 31,  
     2008     2009  
     Net
Revenues
         Net
Revenues
     %  
     (in millions of $, except for percentages)  

FTE-based net revenues

     47.8         79.1     56.7         78.4

Fee-for-service-based net revenues

     12.7         20.9        15.6         21.6   
                                  

Total net revenues

     60.5         100.0     72.3         100.0
                                  

Net revenues from FTE-based services increased by 18.4% from $47.8 million in 2008 to $56.7 million in 2009 due to increases in the average number of FTEs and net revenue per FTE. Net revenues from our fee-for-service-based services increased by 23.5% from $12.7 million in 2008 to $15.6 million in 2009. The increase in demand for our FTE-based and fee-for-service-based services was primarily due to an increase in demand for our discovery biology and preclinical development and discovery chemistry services. FTE-based revenues as a percentage of our total net revenues decreased from 79.1% in 2008 to 78.4% in 2009 as we expanded our newer service offerings, such as discovery biology and preclinical development and pharmaceutical development, which are more typically covered by fee-for-service contracts.

Cost of Revenues

Our cost of revenues increased by 19.5% from $40.5 million in 2008 to $48.4 million in 2009, in line with the increase in our net revenues. The increase in our cost of revenues was primarily due to increases in labor, raw materials and overhead costs. Our labor costs increased from 2008 to 2009 primarily due to the increase in our headcount and the hiring of more senior scientists for our newer services, such as discovery biology and preclinical development, as well as overall rising labor costs in China. Such increase was partially offset by efficiencies gained by our scientists and by our entry into higher margin services. Our raw material costs as a percentage of our total net revenues decreased from 2008 to 2009 due to our cost control measures,

 

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such as improving raw materials usage efficiencies, as well as our increased bargaining power resulting from economies of scale. Our overhead costs increased as we expanded our facilities and purchased new equipment.

Gross Profit and Margin

Our gross profit increased by 19.4% from $20.0 million in 2008 to $23.9 million in 2009, primarily due to the increase in our net revenues. Our gross margin was 33.0% in each of 2008 and 2009. Our gross margin was negatively impacted in 2009 by our increased labor costs, particularly those of newly hired senior scientists for our newer services still in development. These adverse effects were offset by our improved cost control measures, growth in higher margin services, economies of scale and improvements in operational efficiency.

Operating Expenses

Our total operating expenses increased by 34.8% from $10.1 million in 2008 to $13.6 million in 2009.

Selling and Marketing Expenses. Our selling and marketing expenses increased by 93.0% from $0.8 million in 2008 to $1.6 million in 2009. The increase in selling and marketing expenses in 2009 was partially due to our hiring of several sales and business development personnel in the U.S. and Europe in 2009 to increase market penetration and demand for our services in those regions.

General and Administrative Expenses. Our general and administrative expenses increased by 29.5% from $9.3 million in 2008 to $12.0 million in 2009, primarily due to an increase in the headcount of our senior management and administrative employees.

Other Income

Our other income increased from $0.9 million in 2008 to $1.3 million in 2009, primarily due to an increase in government subsidies.

Other Expenses

Our other expenses decreased from $1.6 million in 2008 to $0.2 million in 2009, primarily due to a gain on foreign exchange forward contracts in 2009 compared to a loss on such contracts in 2008.

Income Tax Expense

Our income tax expense increased from $0.3 million in 2008 to $1.6 million in 2009 primarily reflecting (i) an increase in our effective tax rate from 3% in 2008 to 14% in 2009 as a result of the expiration of the full tax exempt status of some of our PRC subsidiaries and (ii) an increase in income before taxes. See “—Selected Statements of Operations Items—Income Taxes.”

Net Income

As a result of the foregoing, our net income increased from $9.1 million in 2008 to $9.8 million in 2009.

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Net Revenues

Our net revenues increased by 74.5% from $34.7 million in 2007 to $60.5 million in 2008, primarily due to an increase in the number of customers and our expanded scope of services. We provided services to 99 customers in 2008 compared to 71 customers in 2007. Our average net revenues per top ten customer increased

 

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from $2.9 million in 2007 to $4.7 million in 2008. The following table sets forth our FTE-based net revenues and fee-for-service-based net revenues by amount and as a percentage of our total net revenues for the periods indicated:

 

     Year Ended December 31,  
      2007     2008  
     Net Revenues      %     Net Revenues      %  
     (in millions of $, except for percentages)  

FTE-based net revenues

     29.9         86.0     47.8         79.1

Fee-for-service-based net revenues

     4.8         14.0        12.7         20.9   
                                  

Total net revenues

     34.7         100.0     60.5         100.0
                                  

Net revenues from FTE-based services increased by 60.4% from $29.9 million in 2007 to $47.8 million in 2008 due to increases in the average number of FTEs and net revenue per FTE. Net revenues from our fee-for-service-based services increased by 161.1% from $4.8 million in 2007 to $12.7 million in 2008. The increase in demand for our FTE-based and fee-for-service-based services was primarily due to an increase in demand for our core discovery chemistry services and, to a lesser extent, for our newer services, such as discovery biology and preclinical development and pharmaceutical development, which grew at a higher rate than discovery chemistry. FTE-based revenues as a percentage of our total net revenues decreased from 86.0% in 2007 to 79.1% in 2008 as we expanded our newer service offerings, such as discovery biology and preclinical development and pharmaceutical development, which are more typically covered by fee-for-service contracts.

Cost of Revenues

Our cost of revenues increased by 77.6% from $22.8 million in 2007 to $40.5 million in 2008, in line with the increase in our net revenues. The increase in our cost of revenues was primarily due to increases in labor, raw materials and overhead costs. Our labor costs increased from 2007 to 2008 primarily due to the increase in our headcount, appreciation of Renminbi relative to the U.S. dollar and the hiring of more senior scientists for our newer services, as well as overall rising labor costs in China. Such increase was partially offset by efficiencies gained by our scientists and by our entry into higher margin services. Our raw material costs as a percentage of our total net revenues decreased from 2007 to 2008 due to our cost control measures, such as improving raw materials usage efficiencies, as well as our increased bargaining power resulting from economies of scale. Our overhead costs increased from 2007 to 2008 partially due to depreciation of expanded or improved facilities and equipment.

Gross Profit and Margin

Our gross profit increased by 68.5% from $11.9 million in 2007 to $20.0 million in 2008, primarily due to the increase in our net revenues. Our gross margin decreased from 34.2% in 2007 to 33.0% in 2008. Our gross margin was negatively impacted in 2008 by the appreciation of the Renminbi relative to the U.S. dollar and increased labor costs, particularly those of newly hired senior scientists for our newer services that were still at the development stage. These adverse effects were partially offset by our improved cost control measures, growth in higher margin services, increases in net revenue per FTE, economies of scale and improvements in operational efficiency.

Operating Expenses

Our total operating expenses increased by 124.8% from $4.5 million in 2007 to $10.1 million in 2008.

Selling and Marketing Expenses. Our selling and marketing expenses increased by 61.2% from $0.5 million in 2007 to $0.8 million in 2008. The increase in selling and marketing expenses in 2008 was primarily due to the hiring of more sales and business development personnel.

 

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General and Administrative Expenses. Our general and administrative expenses increased by 133.1% from $4.0 million in 2007 to $9.3 million in 2008, primarily due to (i) an increase in the headcount of our senior management and administrative employees, (ii) an increase in professional services expenses, principally auditing and general consulting fees and (iii) an increase in depreciation and amortization of property, equipment and software.

Other Income

Our other income increased from $0.2 million in 2007 to $0.9 million in 2008, primarily due to an increase in rental income from the sublease of excess space at the leased animal facility in Shanghai Zhangjiang Hi-Tech Park and an increase in government subsidies.

Other Expenses

Our other expenses increased from $0.1 million in 2007 to $1.6 million in 2008, primarily due to an increase in foreign exchange loss and a loss on foreign exchange forward contracts in 2008.

Income Tax Expense

Our income tax expense increased from $0.2 million in 2007 to $0.3 million in 2008.

Net Income

As a result of the foregoing, our net income increased from $7.5 million in 2007 to $9.1 million in 2008.

 

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Selected Quarterly Results of Operations

The following table sets forth our unaudited condensed consolidated quarterly results of operations for the six quarters ended June 30, 2010. You should read the following table in conjunction with our consolidated financial statements and the related notes included elsewhere in this prospectus. We have prepared the unaudited condensed consolidated quarterly financial information on the same basis as we have prepared our audited consolidated financial statements. The unaudited condensed consolidated financial information includes all adjustments, consisting only of normal and recurring adjustments, that we consider necessary for a fair statement of our financial position and operating results for the quarters presented.

 

     Three Months Ended  
     March 31,
2009
    June 30,
2009
    September 30,
2009
    December 31,
2009
    March 31,
2010
    June 30,
2010
 
     (in millions of $)  

Net revenues

     15.1        17.6        19.8        19.8        19.7        21.8   

Cost of revenues

     (9.9     (11.9     (13.3     (13.3     (12.8     (14.4
                                                

Gross profit

     5.2        5.7        6.5        6.5        6.9        7.4   
                                                

Operating expenses:

            

Selling and marketing

     (0.3     (0.3     (0.4     (0.5     (0.5     (0.6

General and administrative

     (2.7     (3.0     (3.1     (3.3     (3.3     (3.6
                                                

Total operating expenses

     (3.0     (3.3     (3.5     (3.8     (3.8     (4.2
                                                

Profit from operations

     2.2        2.4        3.0        2.7        3.1        3.2   

Interest income

     *        *        *        *        *        *   

Interest expense

                                 *        *   

Other income

     0.2        0.6        0.1        0.3        0.2        1.4   

Other expenses

     (0.1     *        *        (0.1     (0.2     *   
                                                

Income from operations before income taxes

     2.3        3.0        3.1        2.9        3.1        4.6   

Income taxes

     (0.3     (0.4     (0.4     (0.4     (0.4     (0.5
                                                

Net income

     2.0        2.6        2.7        2.5        2.7        4.1   
                                                

 

* Less than $50,000.

Our quarterly net revenues generally increased in the six quarters ended June 30, 2010, although our net revenues were flat from the third quarter of 2009 to the first quarter of 2010. The general increases in our quarterly net revenues were attributable primarily to a larger customer base and a broader scope of services we provided to our customers. The global pharmaceutical and biotechnology industry has experienced significant consolidation and, during the global financial crisis, some pharmaceutical and biotechnology companies experienced financial difficulties. As a result, some of our customers reduced their R&D budgets in 2009. We believe our general growth in net revenues in 2009 and the first half of 2010 despite industry consolidation and the global financial crisis reflected our customers’ recognition of our high-quality, integrated services. Our net revenues were flat from the third quarter of 2009 to the first quarter of 2010, primarily due to (i) consolidation in the global pharmaceutical and biotechnology industry and the global financial crisis in late 2009 and (ii) fewer working days in the first quarter in the PRC as a result of traditional Chinese holidays. Our quarterly revenues and operating results may continue to experience fluctuations in the future due to numerous factors. See “Risk Factors—Risks Related to Our Business and Industry.”

Liquidity and Capital Resources

Our primary sources of liquidity have historically been cash generated from operating and financing activities, which consisted of a private placement of preferred shares. As of June 30, 2010, we had approximately

 

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$10.0 million in cash. As of September 30, 2010, we had an available short-term revolving bank credit facility for up to an aggregate principal amount of $5.0 million, under which the actual amounts available for drawdown are subject to, among other things, the amounts of approved accounts receivable that we assign to the relevant bank. As of the same date, we had a short-term revolving bank credit facility of $2.0 million and a three-year term loan commitment of $5.0 million from the same bank, both of which will be secured by properties owned by one of our subsidiaries. No amounts had been drawn down under these facilities and term loan commitment as of September 30, 2010. In addition, we had short-term revolving bank credit facilities of RMB35.0 million, or $5.1 million. As of September 30, 2010, no amounts had been drawn down under these facilities. In July 2010, one of our subsidiaries entered into a loan agreement with a bank for a one-year working capital loan of up to RMB10.0 million ($1.5 million). As of September 30, 2010, we had drawn down RMB5.0 million ($0.7 million) under this loan.

We expect to require cash to fund our ongoing business needs, particularly salary and benefits and material costs and expenses. Other cash needs include primarily the working capital for our daily operations, expenditures related to our manufacturing facility and laboratory services building in Fengxian, Shanghai, and purchase of equipment for our laboratory services. We believe that our cash, anticipated cash flow from operations, the net proceeds we expect to receive from this offering and proceeds from our bank credit facilities will be sufficient to meet our anticipated cash needs for the next 12 months, including the construction of our manufacturing facility and laboratory services building in Fengxian, Shanghai. The following table sets forth a summary of our cash flows for the periods indicated:

 

     For the Year Ended December 31,     For the Six Months
ended June 30,
 
         2007             2008             2009             2009             2010      
     (in millions of $)  

Net cash provided by operating activities

     8.5        10.2        14.7        5.0        3.8   

Net cash used in investing activities

     (9.0     (14.1     (18.3     (13.2     (8.1

Net cash provided in financing activities

     17.7                             2.1   

Effect of foreign exchange rate changes on cash

     0.1        0.1        *        *        *   
                                        

Net increase (decrease) in cash

     17.3        (3.7     (3.6     (8.2     (2.2

Cash at the beginning of the year

     2.3        19.6        15.8        15.8        12.2   
                                        

Cash at the end of the year

     19.6        15.8        12.2        7.6        10.0   
                                        

 

* Less than $ 50,000.

Operating Activities

Net cash provided by operating activities consisted primarily of our net income increased by non-cash adjustments, such as depreciation and amortization of property, equipment and software, and adjusted by changes in assets and liabilities, such as accounts receivable, accounts payable and amounts due to related parties. Net cash provided by operating activities increased, year over year, primarily as a result of increases in net income, driven by our expanding revenue base. The increases in our accounts receivable were primarily due to the growth of our business and timing of revenue recognized and collection of accounts receivable. The increases in our accounts payable and amounts due to related parties, which are primarily our suppliers, were largely due to increased purchases related to the growth of our business and the timing of our payables.

Net cash provided by operating activities amounted to $3.8 million in the six months ended June 30, 2010, primarily attributable to net income of $6.9 million and add-back of certain non-cash adjustments such as depreciation and amortization of $3.2 million, partially offset by an increase of $2.8 million in accounts receivable.

Net cash provided by operating activities amounted to $14.7 million in 2009, primarily attributable to net income of $9.8 million, and add-back of certain non-cash adjustments such as depreciation and amortization

 

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of $5.9 million and an increase of $1.5 million in accounts payable, partially offset by an increase of $4.8 million in accounts receivable.

Net cash provided by operating activities amounted to $10.2 million in 2008, primarily attributable to net income of $9.1 million and an add-back of certain non-cash adjustments such as depreciation and amortization of $4.3 million, partially offset by an increase of $3.8 million in accounts receivable and a decrease of $1.7 million in income taxes payable related to the payment of income taxes for the years before 2007.

Net cash provided by operating activities amount to $8.5 million in 2007, primarily attributable to net income of $7.5 million, an add-back of certain non-cash adjustments such as depreciation and amortization of $2.1 million and an increase of $1.6 million in amounts due to related parties, partially offset by an increase of $4.1 million in accounts receivable.

Investing Activities

Net cash used in investing activities largely reflects our capital expenditures, which consist of purchases of property, equipment and software made in connection with the expansion and upgrade of our laboratory facilities as well as purchase of land use rights. We expect our net cash used in investing activities in 2010 to increase as we continue constructing our manufacturing facility and laboratory services building in Fengxian, Shanghai.

Net cash used in investing activities amounted to $8.1 million in the six months ended June 30, 2010, primarily attributable to $7.9 million in purchase of property, equipment and software.

Net cash used in investing activities amounted to $18.3 million in 2009, primarily attributable to $14.0 million in purchases of property, equipment and software and $4.2 million in purchase of land use rights for our manufacturing facility in Fengxian, Shanghai.

Net cash used in investing activities amounted to $14.1 million in 2008, primarily attributable to $13.6 million in purchases of property, equipment and software.

Net cash used in investing activities amounted to $9.0 million in 2007, primarily attributable to $8.9 million in purchases of property, equipment and software.

Financing Activities

Net cash provided by financing activities amounted to $2.1 million for the six months ended June 30, 2010, attributable to a $2.1 million borrowing under a short-term revolving bank credit facility.

Net cash provided by financing activities amounted to $17.7 million in 2007, attributable to $20.4 million proceeds from the issuance and sale of our preferred shares, partially offset by $2.6 million dividends paid to our then existing shareholders prior to the issuance and sale of our preferred shares. We did not have any inflows or outflows from financing activities in 2008 and 2009.

Capital Expenditures

We incur capital expenditures primarily for purchases of property, equipment and software and land use rights, the construction of facilities and leasehold improvements. Our capital expenditures were $8.9 million in 2007, $13.6 million in 2008 and $18.2 million in 2009. Our capital expenditures in 2010 are estimated to be approximately $30.0 million, of which we had spent $7.9 million as of June 30, 2010. Our primary planned capital expenditures for rest of 2010 are the construction of our manufacturing facilities and laboratory services building in Fengxian, Shanghai and purchase of equipment for our headquarters in Shanghai Zhangjiang Hi-Tech

 

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Park. As of June 30, 2010, our capital commitments for new plant construction and equipment purchases were $7.7 million.

Contractual Obligations

The following table sets forth our contractual obligations as of December 31, 2009:

 

     Payment Due by Period  
     Total      Less
than
1 year
     1-3
years
     3-5
years
     more
than
5 years
 
     (in millions of $)  

Operating Lease Obligations(1)

     6.4         2.9         2.9         0.6           

Capital Commitments

     6.7         5.2         1.5                   
                                            

Total

     13.1         8.1         4.4         0.6           
                                            

 

(1) Operating lease obligations are primarily related to the lease of office space and vehicles.

Off-Balance Sheet Commitments and Arrangements

We do not have any outstanding off-balance sheet guarantees, interest rate swap transactions except for certain foreign currency forward contracts as discussed in “—Quantitative and Qualitative Disclosure about Market Risk” below. We do not engage in trading activities involving non-exchange traded contracts. In our ongoing business, we do not enter into transactions involving, or otherwise form relationships with, unconsolidated entities or financials partnerships that are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Quantitative and Qualitative Disclosure about Market Risk

Foreign Exchange Risk

Fluctuations in exchange rates affect our cost of revenues and net income and significantly impact our operating margins, because our net revenues are primarily generated from sales denominated in U.S. dollars, and a majority of our cost of revenues and operating expenses are denominated in Renminbi. In addition, we are exposed to foreign exchange risk related to cash and cash equivalents dominated in U.S. dollars.

The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in China’s political and economic conditions. The conversion of Renminbi into foreign currencies, including the U.S. dollar, has been based on rates set by the People’s Bank of China. On July 21, 2005, the PRC government changed its policy of pegging the value of the Renminbi to the U.S. dollar and began allowing modest appreciation of the Renminbi versus the U.S. dollar. Under the new policy, the Renminbi is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies, and the People’s Bank of China continues to intervene in the foreign-exchange market to prevent significant short-term fluctuations in the Renminbi-dollar exchange rate. This change in policy resulted in an appreciation of approximately 22.0% of the Renminbi against the U.S. dollar from July 21, 2005 to June 30, 2010. On June 20, 2010, the People’s Bank of China announced that the PRC government would further reform the Renminbi exchange rate regime and increase the flexibility of the exchange rate. It is difficult to predict how this new policy may impact the Renminbi exchange rate.

To the extent that we need to convert U.S. dollars into Renminbi for our operations, appreciation of the Renminbi against the U.S. dollar would have an adverse effect on the Renminbi amount that we receive from the conversion. Conversely, if we decide to convert our Renminbi into the U.S. dollar for the purpose of paying dividends on our ordinary shares or ADSs or for other business purposes, appreciation of the U.S. dollar in

 

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relation to the Renminbi would negatively affect the corresponding U.S. dollar amount available to us. Considering the amount of our cash denominated in U.S. dollars as of June 30, 2010, a 1.0% change in the exchange rates between the Renminbi and the U.S. dollar would result in an increase or decrease in the amount in the Renminbi of RMB0.50 million to our total cash denominated in U.S. dollars. In addition, if we were to convert the net proceeds received in this offering into the Renminbi, a 1.0% change in the exchange rate between the Renminbi and the U.S. dollar would result in an increase or decrease in the amount we receive in the Renminbi by RMB2.7 million.

We periodically purchase derivative financial instruments, such as foreign-exchange forward contracts, to manage our exposure to Renminbi-U.S. dollar currency-exchange risk. The counterparties for these contracts are generally banks. The maturity periods of these contracts range from one to 18 months. We recorded losses of nil and $0.7 million on foreign-exchange forward contracts in 2007 and 2008, respectively. We recorded a gain of $0.1 million and $1.0 million on foreign-exchange forward contracts in 2009 and the six months ended June 30, 2010, respectively. Our accounting policy requires us to mark to market at the end of each reporting period and to recognize the change in fair value in earnings immediately. We held foreign-exchange forward contracts with an aggregate notional amount of $120.0 million as of June 30, 2010. As of June 30, 2010, the forward contracts had a fair value of $1.0 million.

Interest Rate Risk

Our exposure to interest rate risk primarily relates to the interest income generated by bank deposits with original maturities of three months or less. We have not used any derivative financial instruments to manage our interest risk exposure. Interest-earning instruments carry a degree of interest rate risk. We have not been exposed to material risks due to changes in interest rates. However, our future interest income may be lower than expected due to changes in market interest rates.

Inflation

Inflation in China has not materially impacted our results of operations in recent years. According to the National Bureau of Statistics of China, the change of consumer price index in China was 4.8%, 5.9%, and (0.7)% in 2007, 2008 and 2009, respectively.

Recent Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board, or the FASB, issued an accounting standard update on revenue recognition relating to multiple deliverable revenue arrangements. The fair value requirements of existing accounting guidance are modified by allowing the use of the “best estimate of selling price” in addition to vendor-specific objective evidence, or VSOE, and third-party evidence, or TPE, for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted. The FASB also issued an update in the same month that amends the scope of pre-existing software revenue guidance by removing from the existing guidance on software revenue recognition non-software components of tangible products and certain software components of tangible products. These updates require expanded qualitative and quantitative disclosure and they are effective for fiscal years beginning on or after June 15, 2010 although early adoption is permitted. These updates may be applied either prospectively from the beginning of the fiscal year for new or materially modified arrangement or retrospectively. We are currently assessing the impact that the adoption of these updates will have on our financial statements and disclosures.

In January 2010, the FASB issued an accounting standard update on improving disclosures about fair value measurements. The updated guidance amends existing disclosure requirements by adding required disclosures about items transferring into and out of Levels 1 and 2 in the fair value hierarchy; adding separate

 

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disclosures about purchase, sales, issuances, and settlements relative to Level 3 measurements; and clarifying, among other things, the existing fair value disclosures about the level of disaggregation. This update is effective for fiscal years beginning after December 15, 2009, except for the requirement to provide Level 3 activity of purchases, sales, issuances, and settlements on a gross basis, which is effective beginning the first quarter of 2011. The adoption of this update beginning on January 1, 2010 did not have a material impact on our condensed consolidated financial statements.

In April 2010, FASB issued an update that provides guidance on the criteria that should be met for determining whether the milestone method of revenue recognition is appropriate. A vendor can recognize consideration that is contingent upon achievement of a milestone in its entirety as revenue in the period in which the milestone is achieved only if the milestone meets all criteria to be considered substantive. Determining whether a milestone is substantive is a matter of judgment made at the inception of the arrangement. A milestone should be considered substantive in its entirety. An individual milestone may not be bifurcated. An arrangement may include more than one milestone, and each milestone should be evaluated separately to determine whether the milestone is substantive. A vendor’s decision to use the milestone method of revenue recognition for transactions within the scope of the amendments in this update is a policy election. A vendor that is affected by the amendments in this update is required to provide certain disclosures. This update is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010. Early adoption is permitted with certain disclosures required. A vendor may also elect, but is not required, to adopt the amendments in this update retrospectively for all prior periods. We are evaluating the impact on our financial statements of adopting this standard.

 

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OUR CORPORATE STRUCTURE

We are a Cayman Islands holding company and conduct substantially all of our business through our seven operating subsidiaries in China. We commenced operations in China in 2002 and established the holding company in the Cayman Islands on August 30, 2007. We own 100% of all of our operating subsidiaries in China through two wholly-owned companies, China Gateway Life Science (Holdings) Limited and ChemExplorer Company Limited, which were incorporated in Hong Kong on June 23, 2003 and January 3, 2003, respectively. Our corporate structure reflects common practice for companies with operations in China where separate legal entities are often required or advisable for purposes of obtaining relevant tax and other incentives in the relevant jurisdictions.

The following diagram illustrates our corporate structure and the place of formation of our principal subsidiaries as of the date of this prospectus.

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OUR INDUSTRY

The sections entitled “Overview of the Global CRO Market,” “Overview of the Chinese CRO Market” and “Trends and Outlook for the Global CMO Industry” in this “Our Industry” section contain information and statistics relating to the industry in which we operate that are explicitly stated in the Frost & Sullivan Report, except for CAGR figures. The period CAGR figures are calculated from the respective period’s starting and ending figures, which are explicitly stated in the Frost & Sullivan Report.

Overview of the Global CRO Market

Global R&D spending by pharmaceutical and biotechnology companies grew at a CAGR of approximately 9.1% from $74 billion in 2006 to $96 billion in 2009. R&D spending has been driven primarily by the need to replenish drug pipelines as existing patents for blockbuster drugs expire, the need to develop drugs with significant benefits over existing drugs, and the increased complexity of drug R&D and regulatory processes. Global R&D expenditures are expected to grow at a CAGR of approximately 4.8% from 2009 to 2013 as companies combine their R&D capabilities following industry consolidation and focus their R&D efforts on key therapeutic areas, reaching $116 billion by 2013.

The following chart sets forth the growth of global pharmaceutical and biotechnology R&D expenditures for the years indicated:

Global Pharmaceutical & Biotechnology Companies R&D Expenditures ($ billions)

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CROs provide substantial R&D capacity to drug developers and contribute to global pharmaceutical and biotechnology R&D activities. New drug discovery and development is an expensive and lengthy process, and companies seek to increase R&D productivity and accelerate the drug development process. Meanwhile, competition from generic drug manufacturers and government attempts to reduce public expenditures on drugs have placed pricing and profitability pressures on drug developers, resulting in a need to streamline costs. Many biotechnology companies also seek to make efficient use of their financial resources by reducing investments in internal R&D infrastructure and headcount. As such, many drug developers outsource R&D to service providers, including “off-shoring” or outsourcing drug R&D to service providers in developing countries. Over the past several years, the growth of the global CRO industry has outpaced the growth of global pharmaceutical and biotechnology R&D spending.

 

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The following chart sets forth the growth of the global CRO market for the years indicated:

Global CRO Market ($ billions)

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The following table sets forth the breakdown of the global CRO market by the stages of drug R&D process for the years indicated. See “—Overview of the Drug R&D Process” for more information on the individual stages.

 

R&D Stage    Market Size ($ billions)/% of Market     CAGR  
     2009     2013E     2009 – 2013E  

Discovery

     5.7         26.8     10.2         29.0     15.7

Preclinical Development

     3.9         18.0        6.6         18.9        14.1   

Clinical Phases I – IV

     10.7         50.0        16.7         47.6        11.8   

Others

     1.1         5.2        1.6         4.5        9.8   

Total

     21.4         100.0        35.1         100.0        13.2   

The global CRO market is projected to grow from $21 billion in revenues in 2009 to $35 billion in 2013, representing a CAGR of 13.2%. This growth is primarily due to increases in the level of R&D outsourced by pharmaceutical and biotechnology companies to CROs. In 2006, drug developers outsourced approximately 18.9% of total R&D expenditures. This percentage increased to approximately 21.9% in 2009 and is expected to reach approximately 30.2% in 2013. The growth rate of the drug discovery and preclinical development sectors is expected to exceed the growth rate of the overall CRO market over the same period. This is due to increased outsourcing of these functions to lower cost emerging markets, where intellectual property protection has been improving and technological advances have enhanced the capabilities of CROs.

The principal growth drivers for the global CRO industry include the following:

Cost Containment and Increased Flexibility

The cost of drug development has increased significantly over the past few decades. According to the Pharmaceutical Research and Manufacturers of America, or PhRMA, the cost of developing an FDA approved drug grew from an average of approximately $100 million in 1979 to approximately $800 million in 2000 and approximately $1.2 billion in 2009. The pharmaceutical industry has responded by streamlining R&D operations, diverting resources that would otherwise have been invested in-house to CROs and reducing the level of fixed costs required to maintain R&D internally.

For example, pharmaceutical companies are increasingly outsourcing their drug discovery and preclinical R&D functions and utilizing CROs on an as-needed basis. Because CROs offer their services to multiple customers, they can conduct R&D on a greater scale and more fully utilize capacity, performing R&D at costs lower than those of pharmaceutical and biotechnology companies.

 

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Broad Service Platform As Technical Expertise of CROs Increases

As CROs make advancements in drug R&D, they are offering more sophisticated services. For example, technological advances in target identification and lead generation have enhanced the capabilities of CROs in drug discovery. CROs are also adding new services to create a more integrated R&D platform for their customers. With increased capabilities and broader service offerings, CROs have become an attractive source for pharmaceutical and biotechnology companies in supplementing their R&D functions.

Reduced Time to Market

Reducing time spent on drug discovery and development is crucial as pharmaceutical companies face increasing pressures to bring new drugs to market. Bringing drugs to market more quickly also maximizes the time during which a drug receives patent protection, increasing revenues from the drug. By focusing exclusively on R&D activities, CROs are able to conduct R&D more efficiently. For example, studies have shown that outsourcing could shorten drug discovery cycle time by as much as 30% compared to performing this process in-house at a pharmaceutical or biotechnology company.

Growing Demand from the Biotechnology Sector

Biotechnology companies have been successful in bringing new and innovative therapies to market in areas with significant unmet needs. Studies estimate that one third of all pipeline products are biotechnology-based, a proportion expected to reach approximately 50% within the next three to five years. Biotechnology companies, particularly smaller ones, generally prefer outsourcing R&D services in order to maintain financial flexibility and reduce expenditures required to maintain in-house R&D infrastructure. The strong potential of the biotechnology sector provides significant upside for growth of the overall CRO industry.

Trends and Development of the Global CRO Market

The outlook for the global CRO market remains strong as pharmaceutical and biotechnology companies seek more cost efficient methods to develop new medicines. Drug developers are also expected to increasingly utilize CROs in lower cost regions such as China, India and Eastern Europe to achieve this objective. CROs in these regions are steadily improving their capabilities and offering a range of services that are becoming increasingly comparable to those offered by CROs in developed regions. Meanwhile, international CROs are recognizing the benefits of establishing operations in emerging markets. Because it will take considerable time and effort to build scale in these markets, international CROs are considering alliances or mergers with local companies.

In addition, the CRO industry is expected to evolve towards a more integrated service model to meet the needs of the pharmaceutical and biotechnology industry. Drug developers increasingly prefer using CROs with multiple service capabilities due to shorter turnaround times, elimination of the need to manage multiple CROs and the ability to leverage knowledge obtained at earlier stages of the R&D process within the same organization. The reputation of a CRO is critical in gaining drug developers’ confidence in its capability to deliver quality services in new service areas. As a result, larger CROs with strong track records have a stronger ability in cross-selling new services to customers.

Recent consolidation in the global CRO industry also demonstrates the willingness of CROs to access new capabilities through acquisitions. Examples include Pharmaceutical Product Development Inc.’s acquisitions of BioDuro, LLC and Excel PharmaStudies, Inc. in China. Acquisitions in emerging countries provide international CROs access to a large pool of skilled scientific talent, lower labor costs and proximity to high growth markets.

Overview of the Chinese CRO Market

As outsourcing R&D has become a major trend in the global CRO industry, outsourcing to emerging countries such as China has increased in recent years. The Chinese CRO market grew at a CAGR of 27.2% from

 

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$380 million in 2007 to $615 million in 2009, and is projected to grow at a CAGR of 20.7% to $1.3 billion in 2013.

The following chart sets forth the growth of the Chinese CRO market for the years indicated:

Chinese CRO Market ($ millions)

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The principal growth drivers for the Chinese CRO market include the following:

Lower-cost, High-quality Services

As Western drug developers face rising R&D costs drug developers need to invest in cost-effective R&D to sustain long-term profitability. Leading CROs in China have performed R&D at costs significantly lower than those of Western-based CROs, while meeting Western drug development and safety standards. For example, the average cost of a full time junior and mid-level pharmaceutical researcher in China is significantly lower than that of a similar researcher in Europe or the United States.

In addition, large CROs in China are performing increasingly complicated and integrated R&D processes. With the ability to provide services at lower costs while maintaining standards comparable to Western-based CROs, a greater number of projects, including those that are complex and integrated, are expected to be outsourced to CROs in China.

Large and High-Quality Talent Pool

China offers a large talent pool in pharmaceutical R&D, including a deep base of local graduates and an increasing number of Western-educated researchers and overseas returnees with R&D experience at global pharmaceutical and biotechnology companies. By capitalizing on this talent pool, CROs in China are expected to expand their service offerings and capabilities, driving the overall development of the industry.

Increasing Breadth of R&D Service Offerings

Historically, CROs in China have focused mainly on performing research on discovery chemistry. However, more established and larger CROs in China have increasingly positioned themselves as integrated service providers by expanding into higher value-added activities such as discovery biology, preclinical development and certain pharmaceutical development services, and are offering a broader range of R&D services along the drug development chain. For a Western drug developer, the combination of lower costs in China, quality service and the benefits of using multiple services from a single service provider increase the attractiveness of outsourcing to China.

Large Supply of Treatment Naive Patients

With increasingly stringent protocols being implemented for new clinical trials, it is becoming more difficult for pharmaceutical companies to recruit a sufficient number of volunteer patients in clinical trials within

 

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the specified timeframe of a trial. Approximately 80% of delayed projects are caused by the inability to recruit the required number of patients for clinical trials. As the most populous country in the world, China offers a large patient pool, which facilitates patient recruitment in clinical trials. Conducting clinical trials in China constitutes an attractive strategy for drug developers, benefiting CROs that conduct clinical trials in China.

Growing Domestic Pharmaceutical Market

The Chinese pharmaceutical and biotechnology market provides an additional source of revenue for CROs, as local Chinese and multinational companies increasingly develop innovative products and biologics in China. This contrasts with Chinese companies’ past strategy of focusing on contract manufacturing, API and generic drug production, increasing opportunities for CROs in China. International pharmaceutical companies have also recognized the high growth potential of the pharmaceutical and biotechnology market in China. As a result, they are investing in drugs that target the local population and are leveraging the expertise of local CROs to bring these medicines to market.

Strong Government Support

The Chinese government continues to provide strong support for R&D in China. Tax relief, direct funding opportunities, investment in logistics and infrastructure and other measures have attracted investment in R&D. Increased career opportunities in China have also encouraged scientific personnel to remain in the country or return from abroad. In addition, the government has strengthened intellectual property regulations. These factors have increased the attraction of conducting drug R&D activities in China.

Competitive Landscape of the Chinese CRO Industry

The Chinese CRO market has over 100 domestic and international CROs operating in China. The majority of CROs operating in China are small or medium sized while large CROs, especially domestic companies, remain scarce. The top two CROs, WuXi PharmaTech and our company, in aggregate accounted for approximately 40% of the CRO market in China in 2009.

Despite the large number of CROs in China, companies vary widely in terms of service quality and capabilities. Small and medium sized CROs typically offer low-value added services in a competitive market. Larger CROs differentiate themselves by the quality of their scientific talent, the breadth of the services offered and advanced facilities. In addition, most small to medium sized domestic CROs focus on a limited number of services, with only a few large CROs in China capable of providing integrated services.

In addition, services offered by domestic and international CROs differ considerably. In general, most domestic CROs provide services at the earlier stages of the drug R&D chain, such as drug discovery and preclinical development services. In contrast, international CROs in China generally focus on services at the clinical stages. For example, an international CRO may conduct a clinical trial in China for a global client as part of a multi-country research project for the same drug. However, recent proposed and completed cross-border acquisitions into China reflect the desire of a growing number of international CROs to offer a fuller range of services.

Trends and Outlook for the Chinese CRO Industry

The China CRO industry remains at an early stage of development. With cost advantages and enhanced capabilities, Chinese CROs are expected to become increasingly competitive internationally. The market outlook for drug discovery and preclinical development outsourcing in China remains strong, as Western pharmaceutical companies outsource their early stage R&D to China, driven by competitive costs, improved technologies and intellectual property protection, quality of scientific talent and increasing range of service offerings in China.

 

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As the Chinese CRO market grows, large and reputable CROs who provide broad, integrated services are expected to benefit as customers increasingly value the advantages of an integrated service platform. These organizations are expected to expand their service offerings. In addition, the Chinese CRO industry is expected to consolidate due to the large number of small CROs in the industry. Organizations that provide quality and innovative R&D services are attractive acquisition candidates for larger CROs seeking to expand their service offerings and acquire new capabilities instead of developing them internally. Meanwhile, small and inefficient CROs that offer undifferentiated and a narrow range of services are likely to have difficulties competing in an evolving landscape.

Trends and Outlook for the Global CMO Industry

Pharmaceutical companies are increasingly turning to contract manufacturing organizations, or CMOs, to capture efficiencies and minimize costs required to maintain facilities, up-to-date equipment and skilled personnel. Outsourcing also allows drug developers to achieve scalability in capacity as production volumes fluctuate and provides access to the latest manufacturing expertise and technologies. As a result, CMOs are evolving into strategic partners of pharmaceutical and biotechnology companies. In addition, Western drug developers have increased their focus on CMOs in countries such as China and India in the past few years due to significant cost savings, improving manufacturing capabilities and greater adherence to global manufacturing standards. The global CMO market grew by CAGR of 10.0% from $30 billion in 2005 to $44 billion in 2009, and is expected to grow at a CAGR of 7.9% to reach $60 billion in 2013.

Overview of the Drug R&D Process

R&D is a long, challenging process requiring skill and persistence. The R&D process involves multiple stages, disciplines and personnel. From initial laboratory testing to approval by the FDA, the process typically lasts an average of 10 to 15 years. The rate of success is low, with only one out of approximately every 5,000 to 10,000 compounds tested eventually becoming a commercial drug. The small number of products that receive FDA approval may require years of additional research and surveillance. The chart below summarizes the typical stages of the R&D process:

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Source: PhRMA

Drug Discovery

Target Discovery

Target discovery represents the first step in the drug discovery process. Scientists identify a “target,” or cellular or genetic material in the body believed to be associated with a disease, as a focus for pharmaceutical development. Scientists attempt to identify a target and investigate how the target functions and why it causes the disease. Scientists then develop drugs to treat these disease-causing mechanisms.

 

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Assay Development

After identifying a target, scientists develop evaluation systems to assess the therapeutic values of compounds. These systems, known as “assays,” screen out a large number of compounds based on their therapeutic values. Assays developed for screening compounds are typically in vitro assays ranging from enzyme assays to cell/tissue assays, which evaluate the precision and potency of the reaction between a compound and the target. In vivo assays that involve animals in preclinical development test the physiological effects of the potential drug on animals to evaluate the safety and efficacy of the drug.

Lead Generation

After assays are developed and validated, scientists test large libraries of compounds for their ability to interact with the target and its biologic function. These compounds include small molecules, antibodies, proteins and genes. Scientists identify each compound that reacts with the target as a “hit,” which serves as a starting point for identifying leads. Scientists design new analogs around the hit and develop structure activity relationships, or SAR, to identify leads.

Lead Optimization

In lead optimization, scientists synthesize and screen compounds structurally similar to a lead to improve the qualities of the lead. These qualities include potency, selectivity, physicochemical properties, pharmacokinetic properties, in vivo efficacy and safety profile. Other factors scientists consider in deciding which leads or compounds to develop include ease of synthesis and the number of steps required to produce large quantities of the drug which impact costs and development time. The optimized leads that show desired properties will become potential drug candidates for preclinical development.

Preclinical Development

Preclinical development is a stage of drug research conducted before clinical trials. The purpose of preclinical development is to evaluate the drug metabolism, pharmacokinetics, safety profiles and other properties of a potential drug candidate before testing on humans. During preclinical development, scientists evaluate a compound’s safety profile and biological properties using in vitro and in vivo testing methods.

DMPK

DMPK refers to drug metabolism and pharmacokinetics. DMPK studies attempt to determine the absorption and distribution of an administered drug, the rate at which a drug takes effect, the duration a drug maintains its effects and what happens to the drug after being metabolized by the body. Scientists modify a drug candidate based on the results of these studies.

ADME Profiling

ADME profiling studies the disposition of a drug in the human body with respect to absorption, distribution, metabolism and excretion. When a drug is administered, it must overcome multiple obstacles presented by the body’s physiological and biochemical processes as well as defense mechanisms. For example, the compound may fail to be absorbed into the bloodstream to reach tissues or organs because the compound is insoluble, or the compound may break down after entering the body as metabolism occurs. The human body must also be able to eliminate the drug from the body using natural processes. As a result, scientists evaluate ADME profiles of compounds for their suitability as drug candidates. Typically, scientists perform these studies on animals referred to as PK profiling, or on cells or cellular components such as proteins or enzymes using an in vitro approach, referred as in vitro ADME profiling.

 

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Toxicology Studies

The main goals of toxicology studies are to determine a product’s ultimate safety profile for human use. Typically, both in vitro and in vivo animal tests will be performed for the safety assessment. Studies of a drug’s toxicity include which organs are targeted by that drug, as well as assessing whether there are any long-term carcinogenic or toxic effects. The information collected from these studies is vital so that safe human testing can begin.

Metabolite Identification

When a drug is administered into the body, it metabolically modifies into products known as metabolites. In some cases, the metabolite is actually the drug that is active but often unstable. By identifying metabolites in the body during the different phases of metabolism, research scientists can map the metabolite pathway of a drug candidate. Early identification of potentially active or toxic metabolites can help identify more potent and safer drug candidates, helping scientists determine whether a drug candidate warrants further development.

Pharmaceutical Development

Formulation

Scientists must determine an optimal form of dosage before administering a drug to humans to ensure that the drug is stable and will achieve the desired therapeutic effect. This process involves combining the active pharmaceutical ingredient with other ingredients to produce a medicine. Pre-formulation refers to selecting these ingredients by assessing the drug’s physical and chemical properties, and the overall stability of these ingredients when combined under different environmental conditions. Other steps involved in formulation include stabilizing of the active ingredient in bulk form and the formulation of the drug substance into appropriate dosage forms to achieve the desired therapeutic impact.

Process R&D

During drug discovery and the earlier phases of preclinical development, scientists often synthesize leads in relatively small amounts. To meet the demands of later phases of preclinical development and clinical trials, scientists must synthesize larger quantities of the active pharmaceutical ingredient and its intermediates. Process R&D attempts to optimize the synthesis of large quantities of the active pharmaceutical ingredient and its intermediates by evaluating and improving efficiency, supply of raw materials, safety, facility requirement, cost of production, and other conditions during the process.

Manufacturing

Engineers, chemists and other scientists work together to produce high quality drugs on a large scale. Researchers often begin planning mass production prior to regulatory approval to effectively support product market launch. Companies also manufacture smaller batches of APIs and advanced intermediates for clinical research trials.

Clinical Development

Clinical Trials (Phases I – III)

The first phase of clinical trials assesses a drug candidate’s safety and evaluates adverse events to the human body. These studies are usually conducted on small groups of healthy volunteers. The second phase of clinical trials tests the drug candidate in actual patients. Researchers further study the drug candidate’s safety and begin examining its efficacy against the targeted disease. The third phase of clinical trials involves large-scale

 

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trials with hundreds to thousands of patients. Researchers further evaluate the efficacy of the drug candidate on a larger scale and examine rare adverse events, if any, not arising in the first two phases of clinical trials due to sample size.

Commercialization

Upon successful completion of clinical trials, the company submits a New Drug Application, or NDA, to the FDA. The NDA consists of an extensive collection of documents, including results from preclinical and clinical studies and details of the manufacturing plans. The FDA can approve a new medicine, request more information or studies, or deny approval.

Post-approval Research (Phase IV)

Studies and monitoring continue during the market life of the medicine. For example, the FDA may require Phase IV studies to obtain more information about the medicine. The company may also expand the current indication or purpose for which a drug is used, or research additional indications to treat other diseases. Finally, the company must monitor and report adverse events to the FDA.

 

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BUSINESS

Overview

We are a leading China-based pharmaceutical and biotechnology R&D outsourcing company. We provide a broad range of high-quality, integrated services across the drug discovery and development process to international and Chinese pharmaceutical and biotechnology companies. Our services consist of discovery chemistry, discovery biology and preclinical development, pharmaceutical development and biologics services. We offer our services on an FTE basis or a fee-for-service basis. Capitalizing on our broad service offerings, the experience and expertise of our skilled scientists and our state-of-the-art facilities and equipment, we help our customers discover and develop novel drug candidates efficiently. We have a diversified and loyal global customer base. We provide services to over 100 customers, including all of the top ten pharmaceutical and biotechnology companies in the world in terms of 2009 revenues ranked by Frost & Sullivan and a number of fast-growing biotechnology and specialty pharmaceutical companies, as well as renowned academic and research institutions in the U.S. and China. Most of our customers return to us for additional and often larger projects, and all of our top ten customers in each of 2008 and 2009 remain our customers in 2010.

Our experienced and strong R&D team contributes significantly to our market leadership. We have successfully grown our scientific research staff from 988 as of December 31, 2007 to 1,525 as of June 30, 2010. Over 60% of our scientific research staff have post-graduate degrees, including many native Chinese scientists and managers who have returned to China after studying or working overseas with experience in global pharmaceutical and biotechnology companies and knowledge of Western business practices. Based in China and headquartered in Shanghai, we are well-positioned to attract a large number of returnees and benefit from an abundant supply of highly skilled, domestically-trained scientific talent in China. We attract, retain and motivate our employees through a comprehensive training and career development program and equity incentive plans.

We conduct our laboratory activities in four primary facilities in China: (i) an approximately 450,000 square-foot laboratory and headquarters in Shanghai Zhangjiang Hi-Tech Park; (ii) an approximately 13,000 square-foot AAALAC-accredited animal facility in Shanghai Zhangjiang Hi-Tech Park; (iii) an approximately 36,000 square-foot R&D center in Chengdu; and (iv) an approximately 28,000 square-foot manufacturing facility in Nanhui, Shanghai. In addition, we are constructing an approximately 460,000 square-foot cGMP-quality multi-purpose manufacturing facility in Fengxian, Shanghai, designed to manufacture advanced intermediates and active pharmaceutical ingredients, or APIs, for preclinical testing and clinical trials. We are also constructing an approximately 150,000 square-foot laboratory services building in Fengxian, Shanghai primarily for pharmaceutical development services. Our strategic location in China provides us many advantages, including relatively low-cost labor, developed infrastructure and favorable government incentives as well as a large talent pool.

We have experienced significant growth in recent years. Our net revenues increased from $34.7 million in 2007 to $60.5 million in 2008 and $72.3 million in 2009, representing a CAGR of 44.4%, and increased by 27.2% from $32.7 million in the six months ended June 30, 2009 to $41.6 million in the six months ended June 30, 2010. The number of our customers increased from 71 in 2007 to 99 in 2008, 134 in 2009 and 151 in the six months ended June 30, 2010. Our net income increased from $7.5 million in 2007 to $9.1 million in 2008 and $9.8 million in 2009, and increased from $4.6 million in the six months ended June 30, 2009 to $6.9 million in the six months ended June 30, 2010.

Our Strengths

We believe that the following strengths contribute to our success and differentiate us from our competitors:

Leading Market Position with Proven Track Record

We are the second largest China-based pharmaceutical and biotechnology R&D outsourcing company in terms of 2009 revenues, according to the Frost & Sullivan Report. We have a proven track record of customer satisfaction. Our strong R&D capabilities and ability to help customers plan and structure their projects have

 

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enabled us to consistently meet or exceed our customers’ key performance targets. We have established widespread brand recognition among leading global pharmaceutical and biotechnology companies and in the CRO industry. For example, Lilly, our largest customer in 2009 and the six months ended June 30, 2010, has listed us as a “Global Preferred Partner.” We are a preferred provider of outsourced discovery services to GSK. We were also named as the “Most Valuable Partner” by Roche in 2009, and received an “Excellent Performance Award” from Sunovion Pharmaceuticals Inc. (formerly known as Sepracor Inc.) in 2008.

We have experienced significant organic growth in recent years. Our net revenues increased from $34.7 million in 2007 to $72.3 million in 2009, representing a CAGR of 44.4%, and increased by 27.2% from $32.7 million in the six months ended June 30, 2009 to $41.6 million in the six months ended June 30, 2010. The number of our customers increased from 71 in 2007 to 134 in 2009 and 151 in the six months ended June 30, 2010. Most of our customers return to us for additional and often larger projects. Our average net revenues per top ten customer increased from $2.9 million in 2007 to $4.7 million in 2009 and were $2.6 million in the six months ended June 30, 2010.

Seasoned Management and Experienced R&D Team

We have grown from a start-up company focusing solely on discovery chemistry to a provider of broad, integrated drug discovery and development R&D services, with 1,755 employees as of June 30, 2010. Our management team has in-depth industry knowledge and an average of 13 years of business and financial experience, enabling us to respond quickly and effectively to industry changes and capitalize on market opportunities. We have an experienced and strong R&D team consisting of 1,525 dedicated scientific research staff as of June 30, 2010, 18.4% of whom hold Ph.D.s or M.D.s, 44.3% of whom hold master’s degrees and approximately 8.3% of whom are returnees.

Our R&D team is led by over 100 senior scientists and management who have an average of 13 years of relevant industry experience, including work experience in global pharmaceutical and biotechnology companies such as Lilly, GSK, Merck & Co., Inc. and Amgen Inc. They have published approximately 1,500 scientific papers and are the named inventors on approximately 400 patents. We believe their broad and diverse industry experience enables us to understand our customers’ needs and provide solutions and a customer experience that differentiate us from our competitors. We have also established a scientific advisory board consisting of five world-renowned scientists with significant academic achievements at top universities, such as Harvard and Princeton, and extensive industry experience at leading global pharmaceutical and biotechnology companies. They advise our management and scientists with respect to our R&D services and play an active role in strengthening our scientific expertise.

Integrated Service Platform with Comprehensive Service Offerings

We are one of the few China-based CROs offering a broad range of services, including discovery chemistry, discovery biology and preclinical development, pharmaceutical development and biologics services. Our integrated service platform allows us to cross-sell our services and enhances our service offerings. We work closely with customers to identify additional services that complement the existing services we provide them. We assign a project manager to each multi-service customer project to facilitate knowledge sharing and effective communication and collaboration among our service teams. Our integrated service platform shortens turnaround time and eliminates our customers’ need to manage multiple CROs. Our customers have taken advantage of our comprehensive service offerings. The proportion of net revenues derived from customers who used multiple services from us increased from 58% in 2007 to 89% in 2009.

Loyal and Diversified Global Customer Base

Leveraging our reputation and market leadership, we have established a loyal and diversified global customer base. Our strong commitment to providing customers with high-quality services has helped us build trust with our customers and bring in recurring business. Our top five customers in 2009 have been with us for an average of five years and all of our top ten customers in each of 2008 and 2009 remain our customers in 2010. In

 

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2009, we had 134 customers, including all of the top ten pharmaceutical and biotechnology companies in the world in terms of 2009 revenues ranked by Frost & Sullivan. We have diversified our customer base in recent years, with our top ten customers contributing 65% and 63% of our total net revenues in 2009 and the six months ended June 30, 2010, respectively, compared to 85% in 2007. We also have a number of fast-growing biotechnology and specialty pharmaceutical customers, which contribute a significant portion of our net revenues. Our customers are geographically diversified. In the six months ended June 30, 2010, net revenues originated from North America, Europe, China and the rest of the world represented 81%, 10%, 4% and 5% of our total net revenues, respectively.

Efficient Service Provider with Competitive Cost Structure

As a China-based CRO, we are strategically positioned to benefit from the advantages of doing business in China, including a large talent pool, relatively low-cost labor, developed infrastructure and favorable government incentives. Through the establishment of our Chengdu R&D center, we benefit from additional cost advantages and favorable government incentives in western China. We have built a streamlined and flat reporting system, which improves communication, reduces bureaucratic inefficiencies and improves our responsiveness and flexibility to industry trends and customers’ needs. We have also established a monitoring and control system to help manage our labor, equipment, raw materials and property related costs. This system has enabled us to achieve efficient staffing and maximize the utilization of our equipment, enhancing operating efficiency and profitability. We provide comprehensive training to local hires to increase their productivity and groom them for higher-level positions that would otherwise require returnees.

State-of-the-art Facilities with Flexible and Scalable Capacities

We have state-of-the-art facilities equipped with advanced technologies and equipment. We maintain flexible and scalable service capacities by leasing all of our laboratory and office space except for the manufacturing facility and laboratory services building in Fengxian, Shanghai, which are under construction. Our headquarters in Shanghai Zhangjiang Hi-Tech Park has approximately 450,000 square feet of laboratory and office space and approximately 13,000 square feet of AAALAC-accredited animal facilities. We have approximately 36,000 square feet of laboratory and office space in Chengdu mainly for discovery chemistry.

We are building an approximately 460,000 square-foot cGMP-quality, multi-purpose manufacturing facility in Fengxian, Shanghai, including kilo-labs, a pilot plant and other manufacturing and formulation facilities, to expand our pharmaceutical development services. We are also constructing an approximately 150,000 square-foot laboratory services building in Fengxian, Shanghai primarily for pharmaceutical development services. We use advanced preparatory and analytical equipment from leading global manufacturers such as Agilent Technologies, Inc., Waters Corporation and Shimadzu Corporation. Our equipment provides high-speed and reliable experimental and analytical results, allowing us to consistently deliver high-quality services.

Our Strategies

We aim to become one of the world’s leading pharmaceutical and biotechnology R&D outsourcing companies. To achieve this, we intend to pursue the following strategies:

Broaden Our Service Offerings and Enhance Our Service Capabilities

We intend to broaden the scope of our services to strengthen our integrated service platform and meet our customers’ evolving service needs. Phase A of our Fengxian facility, expected to commence operations in early 2011, will enable us to manufacture advanced intermediates and APIs for preclinical testing and early-stage clinical trials. We began offering biologics services in early 2010 and intend to expand these services. These new services will allow us to provide more integrated services across the drug discovery and development value chain. In addition, we intend to strengthen our leading position in laboratory services by hiring more qualified professionals, enhancing service capabilities, establishing new facilities and investing in advanced equipment. By

 

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focusing on service quality, turnaround time and intellectual property protection, we believe the demand for our services, particularly our higher-value-added services, will increase and drive our growth.

Maintain and Expand Our Customer Base

We seek to maintain and develop long-term and strategic relationships with existing customers by providing high-quality services and consistent project execution. By adding more service offerings to our integrated platform, we will be able to better meet our customers’ evolving needs and strengthen our relationships with them. In addition, we believe the rapid growth of biotechnology and specialty pharmaceutical customers as well as China-based customers represents attractive opportunities. We intend to capitalize on such opportunities through targeted marketing and customized service offerings.

Attract, Train and Retain Scientific Talent

Our skilled scientists constitute our most valuable assets and represent the key to our success. We will continue offering performance incentives to our senior scientists and management, particularly returnees with work experience at leading global pharmaceutical and biotechnology companies. Our performance incentives include performance bonuses and equity awards to reward and motivate our senior scientists and management and provide them the opportunity to share in our success. We will further leverage our senior scientists’ strong expertise and extensive experience by having them provide training in scientific and technical skills to our local hires through programs such as “ShangPharma University.” We also provide training to our employees in compliance, management, leadership and communication skills.

Enhance Our Operating Efficiency

We intend to enhance our operating efficiency through, among other things, the following:

 

   

hiring more local talent and leveraging our senior scientists and management to optimize the structure of our working teams;

 

   

improving employee productivity through effective monitoring of key performance indicators and implementation of a performance-linked compensation structure;

 

   

expanding into lower-cost areas, such as leasing additional R&D facilities and increasing hiring in Chengdu to benefit from lower costs and favorable government incentives; and

 

   

leveraging our scale to obtain better pricing terms from our suppliers.

Selectively Evaluate and Pursue Strategic Alliance and Acquisition Opportunities

In addition to developing new services and enhancing service capabilities, we will prudently and selectively evaluate and pursue strategic alliance and acquisition opportunities to complement our existing services when these opportunities arise. Such opportunities will help us rapidly build new capabilities and broaden our service offerings.

Our Services

We provide a broad range of high-quality, integrated services across the drug discovery and development process to international and Chinese pharmaceutical and biotechnology companies. Our services consist of discovery chemistry, discovery biology and preclinical development, pharmaceutical development and

 

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biologics services. We believe our customers value our ability to offer a wide range of quality services to meet their drug R&D needs, and we expect to capitalize on our strong customer base and expand our service offerings along the drug discovery and development value chain, especially in research manufacturing and biologics.

We conduct our operations primarily at our headquarters in Shanghai Zhangjiang Hi-Tech Park and our R&D center in Chengdu. As a purely China-based contract research company, we are well positioned to capitalize on the advantages of conducting drug R&D operations in China, while also emphasizing quality, responsiveness, protection of customer intellectual property and reliability.

The following chart sets forth the drug R&D process and our services:

LOGO

Discovery Chemistry

Our core service offering is discovery chemistry. In the drug discovery process, we seek to identify hits, which are chemical compounds or therapeutic antibodies or proteins that interact with a potential drug target with sufficient potency and selectivity to warrant further testing and refinement as possible drug candidates, or leads. When we identify and assess a lead, we further refine and optimize the chemical structure of the lead to improve its drug characteristics with the goal of producing a preclinical drug candidate. We believe that our scientists’ extensive experience and expertise enable us to provide discovery chemistry services tailored to our customers’ specific needs. As of June 30, 2010, our discovery chemistry team consisted of 1,037 scientific research staff. Our discovery chemistry services include:

Medicinal chemistry. Our medicinal chemistry services include hit generation and assessment, hit-to-lead and lead optimization services. We focus on a traditional medicinal chemistry approach, a process through which a series of compounds are carefully designed with the aid of modern computational chemistry and SAR analysis, followed by chemical synthesis and evaluations of biological activities and DMPK, ADME or toxicology properties. We also design and synthesize focused libraries to support SAR analysis.

Synthetic chemistry. Our synthetic chemistry services include syntheses of custom-designed compounds, as well as complex reference compounds. We have completed the syntheses of a number of complex compounds with more than 20 steps.

Library generation. Our library generation services include designing and synthesizing libraries, as well as building blocks and scaffold for library synthesis, reference compound synthesis and custom synthesis.

 

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Analytical chemistry. We provide broad analysis and purification services, including high throughput analysis and purification, large scale compound purification, natural product isolation and structure elucidation, among other things. Our analytical chemistry services internally support synthetic chemistry, library generation and medicinal chemistry services, and offer external services focused on chiral separation, bulk material purification and high-throughput library purification.

Discovery Biology and Preclinical Development

Capitalizing on strong customer demand, we began providing discovery biology and preclinical development offerings in 2007 and we believe we are one of the few China-based companies with the capability to provide integrated chemistry- and biology-based drug R&D services. As of June 30, 2010, our discovery biology and preclinical development team consisted of 245 scientific research staff. With increasing customer demand, we anticipate that discovery biology and preclinical development services will increasingly contribute to our growth and profitability.

Discovery Biology

Our discovery biology team provides biology-based assays, models and other services for the drug discovery process, which primarily include:

 

   

Assay development and high throughput screening. We develop biochemical and cell-based assays to examine the activity of small molecule compounds at targets such as kinases, G-protein-coupled receptors, nuclear receptors and ion channels.

 

   

Pharmacology. We develop rodent and other animal disease models to evaluate compounds in various therapeutic categories including cancer, metabolic and central nervous system diseases, inflammation and infectious diseases.

 

   

Reagent generation. We generate and produce proteins, antibodies and cell lines for biochemical and cell-based assays.

Preclinical Development

Our preclinical development team provides biology-based screening, profiling and other services for the drug preclinical development process, which primarily include:

 

   

DMPK. Our DMPK services include in vivo rodent screening based on pharmacokinetic characteristics for rapid drug candidate selection and dog and non-human primate PK for prediction of drug properties in humans. We have the expertise to administer drugs to animals orally, intravenously and by infusion. We perform mass balance studies by administering radioactive drug molecules to animals and monitoring metabolites in plasma, urine, bile and tissue samples.

 

   

ADME profiling. Our in vitro ADME profiling services include analyzing (i) the metabolic stability of drug candidates in cell particles and liver cells, (ii) drug-drug interaction, (iii) plasma protein binding and (iv) the manner in which drugs are transported in the body through transporter assays.

 

   

Metabolite identification. Our metabolite identification services include metabolite profiling, characterization, and structure elucidation as well as pharmacokinetic evaluation of parent and metabolites in preclinical development.

 

   

Bioanalytical services. Our centralized bioanalytical labs provide quantitative and qualitative sample analysis for preclinical studies. In addition to internally supporting DMPK, non-GLP toxicology and biology services, they offer external services such as immunoassay for protein drugs and biomarkers, which are traits, proteins or other substances used to measure or indicate the progress or existence of a disease or condition, and metabolite identification.

 

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Non-GLP toxicology. We offer non-GLP toxicology services, including general toxicology in rodents, dogs and non-human primates. We lease an approximately 13,000 square-foot AAALAC-accredited animal facility in Shanghai Zhangjiang Hi-Tech Park.

Pharmaceutical Development

We provide broad, integrated pharmaceutical development services to our customers in the drug development process. Our pharmaceutical development services focus on the early phases of the drug development process and consist of preformulation and formulation, process R&D, analytical development and research manufacturing services. We began offering pharmaceutical development services in 2005. As of June 30, 2010, our pharmaceutical development services team consisted of 219 scientific research staff. Our pharmaceutical development services include:

 

   

Preformulation and Formulation. Working in close collaboration with our process R&D, research manufacturing and analytical development groups, our preformulation and formulation groups offer a wide range of services for our customers’ new chemical entities in the preclinical stage. Our preformulation group provides analytical approaches to choose the right form of a drug candidate (e.g. solid or liquid), evaluate its physical properties, and understand the drug candidate’s stability under various conditions. Our formulation group focuses on developing the most conventional solid or liquid dosage form or innovative dosage form and drug delivery system for the drug candidate.

 

   

Process R&D. Our process R&D service involves optimizing the chemical synthesis process in order to yield much larger quantities of a drug than those needed in the previous development phases. Processes developed for small scale production of a compound may not be suitable for larger scale production because they may be too expensive, environmentally unacceptable or present safety concerns. Our process R&D team seeks to select and optimize the most effective method of compound synthesis by, among other things, reducing the number of chemicals used in synthesis, improving the yield of the desired compound and reducing the time needed for synthesis.

 

   

Analytical Development. Our analytical development group provides analytical services for pharmaceutical development projects. It supports internal process R&D and offers external services focused on analytical method development, method validation, in-process quality control, reference standard qualification, release testing and stability sample storage testing.

 

   

Research Manufacturing. We provide manufacturing services for our customers to manufacture drug substances under cGMP regulations in sufficient quantities to conduct early stage drug development. Our cGMP-quality kilo-lab in Shanghai Zhangjiang Hi-Tech Park and pilot plant in Nanhui, Shanghai, have the capacity to manufacture drugs in increasing quantities ranging from lab quantities, which are measured in grams, to scale-up quantities, which are measured in kilograms, to process optimization quantities, which are measured in hundreds of kilograms.

We are constructing an approximately 460,000 square-foot cGMP-quality multi-purpose manufacturing facility in Fengxian, Shanghai, which is designed to manufacture advanced intermediates and APIs for preclinical testing and clinical trials. Phase A of the Fengxian facility, comprising approximately 200,000 square feet, will include cGMP-quality kilo-labs and a pilot plant. It is planned to primarily manufacture advanced intermediates and APIs for preclinical testing and early-stage clinical trials and is scheduled to commence operations in early 2011. Phase B of the Fengxian facility, comprising approximately 260,000 square feet, will include a cGMP-quality API plant and a formulation pilot plant. We plan for this facility to primarily manufacture APIs for later-stage clinical trials and potential FDA-approved drugs. We estimate it will commence operations in 2011 or later. We are also constructing an approximately 150,000 square-foot laboratory services building in Fengxian, Shanghai primarily for pharmaceutical development services. This building is expected to commence operations in 2011. We may build additional manufacturing facilities if we experience strong demand for commercial manufacturing of FDA- or EMEA-approved drugs.

 

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Biologics

Capitalizing on the commercial success of therapeutic monoclonal antibodies and recombinant proteins in the past decade and the increasing demand for biologics contract research, we began providing biologics services in early 2010, with an initial focus on the discovery and preclinical stages, to design and implement strategies for the discovery, engineering and delivery of therapeutic antibody and recombinant protein drug candidates for clinical development. As of June 30, 2010, our biologics team consisted of 24 scientific research staff. Our current biologics services primarily include:

 

   

Therapeutic antibody generation. We use hybridoma technology, combined with stringent screening funnels, to identify early therapeutic antibody leads with the desired biological and pharmacological properties. As part of our integrated services, we also develop surrogate antibodies for in vivo studies in animal models for target validation and proof-of-concept analysis.

 

   

Antibody optimization and engineering. We provide humanization design services for selected therapeutic hybridoma antibody leads, and perform laboratory tests and analysis for humanized lead selection. In addition, we perform affinity maturation to improve the binding affinity and biological potency of the humanized antibodies. These services are supported by our strong protein analytical capabilities.

 

   

Analytical services for large molecules. We provide experimental measures to analyze the drug-like properties of therapeutic antibody or recombinant protein drug candidates. Such measures include stability and solubility studies to provide a better understanding of key properties of the drug candidate formulation, as well as pharmacokinetic analysis in rodents and non-human primates.

We intend to further expand our biologics service offerings and offer a broad spectrum of quality biologics services across the drug discovery and development process, including general molecular biology, protein production and purification, cell line generation, epitope mapping and protein crystallography.

Our Facilities

We are headquartered in Shanghai and conduct our laboratory activities in four primary facilities in China:

 

   

An approximately 450,000 square-foot headquarters in Shanghai Zhangjiang Hi-Tech Park, primarily used for discovery chemistry and discovery biology services.

 

   

An approximately 13,000 square-foot AAALAC-accredited animal facility in Shanghai Zhangjiang Hi-Tech Park, primarily used for discovery biology and preclinical development services. We may build or lease additional animal facilities if the demand for our discovery biology and preclinical development services increases.

 

   

An approximately 36,000 square-foot R&D center in Chengdu, primarily used for discovery chemistry services. We have an option to lease additional laboratory and office facilities in Chengdu if the demand for our discovery chemistry services increases.

 

   

An approximately 28,000 square-foot manufacturing facility, including a mini-pilot plant, a kilo-lab and a cleaning room unit, in Nanhui, Shanghai, primarily used for pharmaceutical development services.

Our four primary facilities consist of buildings leased from several property owners, including Shanghai PharmValley Corp., a related party. We have entered into a lease for each building. The leases generally have terms from two to five years and may be renewed by the parties. We generally make rental payments quarterly. Most of our leased buildings are used for office space and research activities.

 

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In addition, we are constructing an approximately 460,000 square-foot cGMP-quality multi-purpose manufacturing facility in Fengxian, Shanghai, designed to manufacture advanced intermediates and APIs for preclinical testing and clinical trials. Phase A of the Fengxian facility is scheduled to commence operations in early 2011 and Phase B of such facility is estimated to commence operations in 2011 or later. We are also constructing an approximately 150,000 square-foot laboratory services building in Fengxian, Shanghai primarily for pharmaceutical development services. This building is expected to commence operations in 2011. We will own the manufacturing facility and laboratory services building in Fengxian. We intend to finance the construction of (i) Phase A of the Fengxian manufacturing facility from cash flow from operations and proceeds from unused bank credit facilities, (ii) Phase B of the Fengxian manufacturing facility from the proceeds of this offering, cash flow from operations and bank loans and (iii) the laboratory services building in Fengxian from cash flow from operations, proceeds from this offering and bank loans. We may build additional manufacturing facilities if we experience strong demand for commercial manufacturing of FDA- or EMEA-approved drugs.

Sales and Marketing

We identify potential customers by actively networking with our existing customers, employees and consultants, conducting market research, participating in trade conferences and shows, and publishing marketing materials, among other activities. We also receive a significant amount of business from customer referrals.

Once we identify a potential customer and after making an initial customer contact, we seek to identify the potential customer’s needs for services and align such needs with our service capabilities either through on-site visits to, or teleconferences with, the potential customer. Subsequently, we typically conduct technical due diligence on the potential customer, make specific project proposals and, if the potential customer desires to use our services, negotiate and enter into a service agreement with the customer. We have entered into master services agreements with some customers, the terms of which typically range from one to five years.

With regard to existing customers, we provide quality services in a cost effective manner and seek to renew our contracts on pricing and other terms that are more favorable to us, as well as to sell other services to these customers. We also intend to increase our customer base by broadening the scope of our service offerings, such as introducing biologics and research manufacturing services. We intend to diversify our customer base by targeting more biotechnology companies, which often lack in-house drug discovery and development capabilities, as well as China-based pharmaceutical and biotechnology companies, which have increasingly focused on R&D efforts and outsourced R&D activities, particularly discovery biology, preclinical development and pharmaceutical development activities.

We have significantly expanded our sales and marketing teams in the U.S. and Europe to increase market penetration in our targeted markets and drive revenues growth.

Customers

Our customers consist primarily of large pharmaceutical and biotechnology companies located throughout the world. We provide services to over 100 customers, including all of the top ten pharmaceutical and biotechnology companies in the world in terms of 2009 revenues ranked by Frost & Sullivan and a number of fast-growing biotechnology and specialty pharmaceutical companies, as well as renowned academic and research institutions in the U.S. and China. We generated a significant majority of our total net revenues over the last three years from sales to customers located in the United States. We have received significant recognition and numerous awards from our customers. For example, Lilly, our largest customer in 2009 and the six months ended June 30, 2010, has listed us as a “Global Preferred Partner.” We are a preferred provider of outsourced discovery services to GSK. We were also named as the “Most Valuable Partner” by Roche in 2009, and received an “Excellent Performance Award” from Sunovion Pharmaceuticals Inc. in 2008. Most of our customers return to us for additional and often larger projects, and all of our top ten customers in each of 2008 and 2009 remain our customers in 2010.

 

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The following table sets forth our growing and recurring customer base:

 

     For the years ended December 31,      For the six
months ended
June 30, 2010
 
     2007      2008      2009     

Top ten customer concentration (% of net revenues)

     85         77         65         63   

Total number of customers

     71         99         134         151   

Number of top ten customers that remain as our customers in 2010

     9         10         10         10   

Average net revenues per top ten customer (millions
of $)

     2.9         4.7         4.7         2.6   

For certain major customers, we provide dedicated teams of scientists, laboratory facilities, analytical support and independent information technology and security services. This physical and operational separation of customer projects ensures enhanced security and protection of our customers’ intellectual property. We can tailor our laboratory configuration and setup, research plan, operating procedures, information technology and security protocols to our customers’ specifications.

Our two largest customers in each of 2007, 2008, 2009 and the six months ended June 30, 2010, Lilly and GSK, respectively accounted for 48% and 14% in 2007, 34% and 13% in 2008, 27% and 10% in 2009, and 20% and 9% in the six months ended June 30, 2010 of our net revenues. No other customer accounted for more than 10% of our net revenues in those periods. See “Risk Factors—Risks Relating to Our Business and Industry—A limited number of our customers have accounted and are expected to continue to account for a high percentage of our revenues. The loss of or significant reduction in orders from any of these customers could significantly reduce our revenues and materially and adversely affect our financial condition, results of operations and prospects.”

We entered into two master laboratory service agreements with Lilly in March 2008 and January 2009, respectively. These agreements will expire in June 2011 and December 2011, respectively. Under these agreements, Lilly may place individual work orders with us for various laboratory services. We are entitled to receive payments for services performed. Lilly may terminate these agreements upon 90-days’ notice for any reason.

We also entered into a global research and development outsourced services agreement with GSK in December 2009 with an initial term of three years. GSK has an option to extend the term for up to additional two years. Under this agreement, GSK may execute individual statements of work or research agreements with us for various laboratory services or research programs. We are entitled to receive payments for services performed. GSK may terminate this agreement upon 90-days’ notice for any reason.

Project Management and Customer Support

We believe that we have an established reputation among our customers for high productivity, rapid turnaround time and comprehensive customer support. We generally assume full project management responsibility in our service offerings. We seek to strictly adhere to our internal quality and project management processes. We believe these processes reduce the overall cost to the customer and enhance the quality and speed of delivery. We have developed a project management methodology to ensure timely, consistent and accurate delivery of quality services. To facilitate project management, we developed an online monitoring and reporting system, allowing a customer’s project manager to monitor the progress of its projects through a secure encrypted website. Additionally, our project team interacts with the customer’s project management team via regular conference calls, daily emails and bi-weekly reports. Our project management follows our strategic imperative to protect our customers’ confidentiality and intellectual property. See “—Intellectual Property” below.

 

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We conduct frequent external customer satisfaction surveys of key performance indicators to improve our planning, execution, evaluation and support. Internally, we focus on operational improvement and innovation to achieve lower direct costs, better use of assets, faster development time, increased accuracy, greater customization or precision, more added value and simplified processes. Our customer support focuses on sales support and relationship management with our customers, and is dedicated to improving responsiveness to our customers’ needs and inquiries. Less than satisfactory feedback is scrutinized for root causes to improve our operations and services.

Employees

We had 1,115, 1,676 and 1,717 employees as of December 31, 2007, 2008 and 2009, respectively. As of June 30, 2010, we had 1,755 employees, including 1,037 in our discovery chemistry group, 245 in our discovery biology and preclinical development group, 219 in our pharmaceutical development group, 24 in our biologics group and 230 non-scientific personnel. Of the total 1,755 employees as of June 30, 2010, 1,549 worked in our headquarters in Shanghai Zhangjiang Hi-Tech Park, 134 worked in our R&D center in Chengdu, 60 worked in our manufacturing facility in Nanhui, Shanghai, seven worked at the construction site for the planned manufacturing facility and laboratory services building in Fengxian, Shanghai, and five worked at our overseas offices. We consider our relations with our employees to be good. The following chart illustrates the composition of our scientific research staff by educational level as of June 30, 2010:

LOGO

As of June 30, 2010, we had 1,525 scientific research staff members, over 60% of whom have post-college degrees. We recruit both recent graduates and experienced professionals. Our primary hiring strategy in China is to recruit from colleagues and universities. We also recruit overseas, primarily focusing on returnees and Ph.D.s with significant educational and/or industry background with major pharmaceutical and biotechnology companies, many of whom used to work for our customers, and through referrals, websites, advertisements in trade magazines and job fairs. We expect to hire a significant number of China-based employees during 2010.

Our future growth and profitability depend upon the research and efforts of our experienced and skilled scientists and mid-level managers, and their ability to keep pace with changes in drug discovery and development technologies. We compete vigorously with pharmaceutical firms, biotechnology firms, contract research firms and academic and research institutions to recruit scientists and mid-level managers and employees. See “Risk Factors—Risks Relating to Our Business and Industry—Our ability to execute projects, maintain, expand or renew existing customer engagements and obtain new customers depends largely on our ability to attract, train, motivate and retain skilled scientists.”

We recognize that our employees constitute our most valuable assets and remain focused on training and retention. We are dedicated to cultivating a corporate culture that is customer centric and people oriented through employees who exhibit a can-do attitude, teamwork and innovation. In addition to on-the-job training programs, we have a comprehensive formal training program for employees at different levels, including orientation programs for recent college graduates, management and leadership training for senior employees, and technical skills training, team building and integration training and communication skills training for domestically-trained

 

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employees. We have implemented a comprehensive review and incentive system that aligns performance and compensation as well as internal promotions, which also help us motivate and retain our employees.

We pay base salaries and bonuses to all of our employees and pay additional awards to some employees for exceptional performance. As required by PRC regulations, for our China-based employees, we participate in various employee benefit plans organized by municipal and provincial governments, including pension insurance, work-related injury benefits, maternity insurance, medical insurance, unemployment benefit plans and housing funds. We are required under PRC law to make contributions to the employee benefit plans for our China employees at specified percentages of the salaries, bonuses and certain allowances of our employees, up to a maximum amount specified by the local government from time to time.

Intellectual Property

Protection of intellectual property associated with drug R&D is critical to our customers. In our business of providing drug R&D services, our customers generally retain ownership of all associated intellectual property, including intellectual property they provide to us and intellectual property arising from the services we provide. Our success therefore depends in substantial part on our ability to protect the proprietary rights of our customers. This is particularly important because a substantial part of our operations are based in China, and China, as well as Chinese companies, have not traditionally enforced intellectual property protection to the same extent as the United States and U.S. companies.

We take necessary precautions to protect the intellectual property of our customers. We have established standard intellectual property protection procedures to control information access on a need-to know basis. We scan laboratory records into our electronic archives periodically and on an as-needed basis. We enter into agreements with all our employees under which they disown intellectual property they create during their employment, and they waive relevant intellectual property rights or claims. Our employees are also bound by confidentiality obligations and have agreed to disclose and assign to us inventions conceived by them during their respective terms of employment. During their entrance interviews, employees are required to confirm in writing that they will not disclose or use the intellectual property obtained from their previous employers and, during the exit interviews, the departing employees are required to confirm their confidentiality obligations to us and our customers in writing. Furthermore, our service agreements provide that all intellectual property generated during a project is exclusively the property of the customer for whom we are conducting the project.

Although our intellectual property rights are important to our results of operations, we believe that factors such as the technical expertise, knowledge, ability and experience of our employees are more important, and that, overall, these technical capabilities provide significant benefits to our customers.

Despite measures we take to protect intellectual property of our customers or our company, unauthorized parties may attempt to obtain and use information that we regard as proprietary. See “Risk Factors—Risks Relating to Our Business and Industry—If we fail to protect the intellectual property rights of our customers, we may be subject to liability for breach of contract and may suffer damage to our reputation.” To date, we are not aware of any material misuse of our proprietary information.

As of September 30, 2010, we had ten registered trademarks in China, two registered trademarks in Japan and two registered trademarks in the Europe Union. We currently have eight pending trademark applications in China, two pending applications in the United States, and two pending applications in India. In addition, we own 47 Internet domain names as of the date of this prospectus.

Competition

We primarily compete with international and Chinese CROs. We anticipate that we will face increased competition as new companies enter the market and advanced technologies become available. See “Risk

 

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Factors—Risks Relating to Our Business and Industry—We face increasingly intense competition. If we do not compete successfully against new and existing competitors, demand for our services and related revenues may decrease and we may be subject to increasing pricing pressure.”

The pharmaceutical and biotechnology R&D outsourcing market remains highly competitive. We compete with WuXi PharmaTech across the breadth of our service offerings. We also compete with industry participants in certain service areas, for example with Albany Molecular Research, Inc. in discovery chemistry and pharmaceutical development, and Cerep S.A. and Covance Inc. in discovery biology and preclinical development.

We compete primarily on the basis of the quality and scope of services, the ability to protect confidential information and intellectual property, the ability to be responsive to and efficient with respect to customers’ requests and pricing. We emphasize high-quality services and place a strategic emphasis on protection of customer intellectual property, both of which result in greater customer acceptance of our services. We also compete on the basis of our relationships with customers. Most of our customers return to us for additional and often larger projects, and all of our top ten customers in each of 2008 and 2009 remain our customers in 2010. We believe our high customer retention rate reflects our customers’ general satisfaction with our services. In addition, we compete on the basis of our turnaround time, resources and geography. We believe we compete favorably on the basis of each of these factors. However, many of our current or future competitors may have longer operating histories, better name recognition, greater levels of consumer trust, stronger management capabilities, better supplier relationships, a larger technical staff and sales force and/or greater financial, technical or marketing resources than we do. In addition, consolidation within the global pharmaceutical and biotechnology R&D outsourcing markets may create stronger competitors than those we currently face.

The successful recruitment and retention of highly qualified scientists is a key element in achieving our strategic goals. We believe that as competitive pressures in the drug R&D industry increase, the recruitment and retention of scientists will become increasingly competitive. To meet this challenge, we actively recruit scientists at colleges and universities and through other means. We believe the sophisticated drug R&D services that we perform and our growth prospects assist us in attracting and retaining highly qualified scientists. We also offer competitive salaries and benefits to recruit and retain highly skilled scientists.

Insurance

We maintain property insurance policies covering physical damage or loss of our equipment, and office furniture, employer’s liability insurance generally covering death or work injury of employees, public liability insurance covering third party bodily injury and property damage incurred in connection with our business within China, and directors and officers liability insurance. We do not have general liability or product liability insurance covering our whole business or all of our products and services. We currently maintain general liability insurance for four contracts covering, among other things, bodily injury and property damages arising out of the products or services provided under these contracts. The aggregate net revenues derived from these contracts in the six months ended June 30, 2010 accounted for 11.0% of our total net revenues in this period. The aggregate maximum coverage amount under the insurance policy for these contracts is $5 million for bodily injury and property damage arising out of our products or services and economic loss sustained by persons or entities due to deficiencies in our products or services. We do not maintain business disruption insurance or key man life insurance. We believe our insurance coverage is customary for companies of comparable size in comparable industries in China. See “Risk Factors—Risks Relating to Our Business and Industry—We have limited insurance coverage, and any claims beyond our insurance coverage may result in our incurring substantial costs and a diversion of resources.”

Environmental Protection and Health and Safety

Our pharmaceutical and biotechnology R&D outsourcing services use highly toxic and hazardous materials. Any failure by us to control the use of, restrict adequately the discharge of, or protect our employees

 

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from hazardous substances could subject us to potentially significant monetary damages and fines or suspensions in our business operations. We are subject to national, provincial and local regulations governing the use, manufacture, handling, storage and disposal of hazardous materials.

We have adopted detailed safety procedures in using lab equipment, operating animal facilities and handling chemical, biological and radioactive materials in compliance with applicable laws and regulations. In addition, many of our major pharmaceutical company customers have audited or inspected our facilities for compliance with their own quality assurance standards.

While we are committed to maintaining high safety standards at our work environment, we cannot completely eliminate the risk of contamination or injury resulting from hazardous materials and we may incur liability as a result of any contamination or injury, which may materially and adversely impact our business, financial condition, results of operations and prospects. We have not completed certain environmental assessment or approval procedures or the procedures required to comply with applicable safety and health laws for some of our facilities or projects. We are taking remedial measures to complete all the required procedures and obtain all the necessary approvals. If the relevant government authorities in China determine that we are not in compliance with applicable laws and regulations, we may be required to rectify non-compliance within a specified period of time frame, pay fines or damages to third parties or suspend our operations. See “Risk Factors—Risks Related to Our Business and Industry—Compliance with environmental regulations can be expensive, and noncompliance with these regulations may result in significant monetary damages, fines and other penalties” and “Risk factors—Risks Related to Our Business and Industry—We are subject to safety and health laws and regulations in China, and any failure to comply could adversely affect our operations.”

Legal Proceedings

We may from time to time be subject to various legal or administrative proceedings, either as plaintiff or defendant, arising in the ordinary course of our business. We are not currently a party to, nor are we aware of, any legal proceedings, investigation or claim that, in the view of our management, is likely to materially and adversely affect our business, financial condition or results of operations.

 

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REGULATION

Regulation of the Pharmaceutical and Biotechnology R&D Industry in China

This section summarizes the principal laws and regulations relevant to our business activities in China.

State Food and Drug Administration

In the PRC, the State Food and Drug Administration, or SFDA, is the authority that monitors and supervises the administration of pharmaceutical products and medical appliances and equipment as well as food and cosmetics.

The SFDA’s primary responsibilities include:

 

   

monitoring and supervising the administration of pharmaceutical products, medical appliances and equipment as well as food and cosmetics in the PRC;

 

   

formulating administrative rules and policies concerning the supervision and administration of food, dietary supplements, cosmetics and the pharmaceutical industry;

 

   

evaluating, registering and approving new drugs, generic drugs, imported drugs and traditional Chinese medicine; and